High Noon for the ECB

Europe’s voters have spoken. Opposition to Brussels’ austerity has reached fever pitch. The clarion call to the European Union (EU) is for more growth and jobs. It is time for action.

This week is High Noon for the European Central Bank (ECB). Thursday’s monetary policy meeting should see new easing measures pulled from the hat. Expectations are running high. The odds are they will fall short of the mark.

The European elections marked a major watershed for change. Europe’s long-suffering electorate expressed its anger at the EU’s ruling elite in Brussels. The tide of protest is rising. Europe’s anti-austerity and euro sceptic parties are tapping in and gaining strong support.

Europe’s mainstream political parties have been shaken to the root. Gathering at a post-election summit, shell-shocked EU leaders were unanimous in pin-pointing faster growth and better employment conditions as vital policy imperatives ahead.

But Europe needs to go much further than this. It needs to dump austerity and kick-start Keynesian-styled reflation policies to fuel faster recovery and boost jobs.

Europe’s cash-strapped governments remain deeply hamstrung though. In the name of austerity, governments’ spending power has been radically constrained by the EU’s tough budget cutting mandate. This has reduced policy-stimulus options to a one-trick pony. Only the ECB is left to fill the gap and lift the Eurozone from the doldrums.

Major hopes are being pinned on the ECB this week. Front-running favourites for new policy initiatives are expected cuts to all the ECB’s key interest rates combined with a package of new measures to boost market liquidity.

Without a doubt, the ECB will be tip-toeing into unchartered waters this week. The ECB should cut its deposit rate into negative territory – possibly to the tune of -25 basis points. This would mark a first for a major central bank. The move is intended to boost lending by penalising banks for hoarding funds at the central bank, encouraging them to open up their doors to new borrowing instead. It is unlikely to be enough.

It is still tinkering at the margins of incisive monetary stimulus. The ECB needs to be much bolder. It needs to take the plunge into quantitative easing (QE) to boost growth and help steer the Eurozone off the rocks of deflation. The ECB does not need to look too far to see how effective QE can be when the chips are down.

The US Federal Reserve and the Bank of England both embarked on major QE programmes during the financial crisis. By printing money to buy assets – and releasing vital swathes of liquidity into their cash-starved economies – it helped secure the turnaround that put the US and UK on the express train to recovery. The ECB needs to do the same.

Unless the ECB intends springing a huge surprise on the markets, the QE option appears sidelined for now. That is despite past promises by ECB President Draghi to do ‘whatever it takes’ to save the euro. It may be the ECB prefers to hold its QE option ‘in reserve’ just in case economic conditions deteriorate once again. The ECB’s monetary arsenal is already dangerously thin with interest rates already at zero.

Delaying QE is taking a big gamble with the Eurozone economy. The recovery still needs to reach critical escape velocity to break free from the clutch of recession. Economic headwinds remain strong. Consumer and business confidence in the Eurozone is rising but is still generally diffident about the outlook ahead. Uncertainty about global economic prospects, worries about the crisis in the Ukraine and the long wait for additional ECB easing have all been clouding the recent picture.

Deflation remains a risk. Inflation has been stuck in the bank’s ‘danger-zone’ below 1% for seven months. The headline rate is currently at 0.7% with a bias still tilted lower considering the tepid demand-pull and cost-push tendencies.

Weak monetary dynamics back up the case for radical ECB action too. Eurozone domestic credit contraction running at -1.8% remains a major block on growth. Weak borrowing demand, restricted credit supply and a low level of economic confidence all compound the weak recovery picture.

The ECB can make a difference by pushing official interest rates into negative territory and forcing the reluctant banks to lend again. But it can do a lot more.

If the ECB can open the door to real quantitative easing, flooding the economy with extra liquidity and weakening the euro at the same time, the impact on the economy would be cathartic. Growth expectations for the Eurozone over the next year could easily double from 1% to over 2%.

Although German exporters may not need it, hard-pressed Eurozone exporters elsewhere would relish the added impetus to competitiveness and growth from a weaker euro.

The euro is already poised on the brink of a major break lower. With the US and UK on the cusp of higher interest rates,  the advent of Eurozone QE could be the nudge that pushes the euro back over the cliff. Euro currency bulls had better beware.

Re-printed by kind permission of South China China Morning Post