It’s time for a sea-change in monetary policy in the Eurozone. The ECB need to take a leaf out of the Federal Reserve and Bank of Japan’s book and go for much bigger monetary reflation. With all the main Eurozone economies bar Germany, deep in the economic doldrums, the ECB need to act fast to turn back the recession tide that has flooded in on the heels of extreme fiscal austerity and perilously weak economic confidence. All the latest sentiment indicators underline that the Eurozone recession is getting a lot worse with no hope of any revival evident on the near term or far horizon. The ECB need to move swiftly to stop the downturn developing into a complete rout and depression risks taking root in some of the more endangered Eurozone economies. Greece, Portugal, Cyprus, Spain and Italy all remain stuck in this deadly risk category.
The Big Easy in monetary reflation happening in the US, Japan and the UK highlights that there is another way to think outside the policy box. The ECB needs to embark on a much bigger monetary stimulus to offset the damage being inflicted by restrictive Eurozone fiscal policy. It needs to stop sporadic fire-fighting and must start using unconventional monetary pump-priming tools, such as the big asset purchase programmes that have been adopted in the US, Japan and the UK. The fledgling revival in the US economy is strong proof that the monetary medicine is working. The ECB’s long term repo operations and country bank bail outs might have filled a temporary gap, but a massive programme of unrestrained QE needs to be concocted pretty soon. That may be complete anathema to the Bundesbank inflation hawks and unquestioningly remains outside of the ECB’s strict policy remit. But the events of the last few years, especially witnessed during the Cyprus crisis recently, have underlined that the ECB have torn up the rule-book in the past and can do so again in the future. If the ECB are going to save the Eurozone’s soul, then it needs to be inventive and act fast.
The ECB cutting rates by a further quarter per cent will do little to correct the mess. A rate cut is probably due in the next few months, but the ECB will need to consider other ways to get monetary life-blood into the economy. The continuing contraction in credit to consumers and the business sector is really worrying. While this partly reflects slower demand thanks to the recession, it also reflects shorter credit supply as Eurozone banks slim down their balance sheets, with new capital adequacy requirements bearing down hard. New credit must be the lifeblood and precursor to any recovery and without it, the Eurozone economy will remain dead in the water. How the ECB lead the banks to the new lending waters and make them imbibe at the same time will be a huge challenge of Gordian proportions. Better to slice through it with gusto if the Eurozone has any chance of recovery or survival.
At least Draghi’s language still sounds right. If the ECB is committed to keep policy accommodative for a long as needed, the outlook for the euro remains much lower. The euro’s demise is two sided now. The weak economy and much easier monetary policy will keep the currency battened down on one side. On the other, the latest IMF COFER report highlights that the euro is starting to lose its appeal as a reserve currency as central banks begin to question its ability to survive in the long run. The COFER report shows that developing countries are starting to ditch some of their euro reserve holdings in favour of other currencies. The Bank of Japan has held up its hand and admitted to a huge new burst of monetary stimulus to get the Japanese economy moving again. The ECB will have to effect a supernova monetary stimulus to return the Eurozone economy to bright star status again.
Altogether, the euro seems set on a much lower trajectory. In the near term, the target looks set to test USD1.25 again, with a further out objective of USD1.20 looking likely in the next 12 months. The possibility of a return to sub-parity remains a measurable risk the longer the ECB fiddles while the Eurozone economy burns.
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