ECB takes out the bazooka

The news: The ECB has  agreed unanimously on implementing a set of quantitative and interest rate measures to boost lending in the euro area and combat the risk of a prolonged period of weak inflation.

On rates:

  • Deposit rates were cut by 10 basis points to -0.10%
  • The main refinancing rate has been cut by 10 basis points to 0.15%
  • The marginal lending facility rate has been cut by 35 basis points to 0.40%
  • ECB President has also stated that these rates will remain unchanged for a prolonged period of time

On the quantitative side:

  • The ECB has announced a programme of Targeted Long Term Refinancing operations, maturing in September 2018, i.e. in around 4 years. Commercial banks will be entitled to borrow, initially, 7% of the total amount of their loans to the euro area non-financial private sector, excluding loans to households for house purchase, outstanding on 30 April 2014. Lending to the public sector will not be considered in this calculation. The combined initial entitlement amounts to some €400 billion. To that effect, two successive TLTROs will be conducted in September and December 2014. In addition, from March 2015 to June 2016, all counterparties will be able to borrow, quarterly, up to three times the amount of their net lending to the euro area non-financial private sector, excluding loans to households for house purchase.
  • The ECB is intensifying preparatory work related to outright purchases in the asset-backed security market to enhance the functioning of the monetary policy transmission mechanism. Under this initiative, the Eurosystem will consider purchasing simple and transparent assets backed by actual plain loans to the private sector.

Our comment:

While markets were widely expecting the rate cuts, the quantitative easing programmes were generally a surprise.

These measures should have important effects on the economy:

1. Starting with negative deposit rates, they should reduce the incentive to hold excess liquidity with central bank and support the devaluation of the euro. However, there are some potential consequences that go beyond the usual effects, that were experienced in Denmark, that introduced negative policy rates in 2012 :

  • Commercial banks may choose to keep their excess reserves with the ECB and transfer the cost to their customers through a cut in the commercial deposit rates and/or a hike in lending rates, which would totally defeat the ECB’s purpose (that happened in Denmark)
  • Commercial banks may reduce the amount of reserves with the ECB but without this implying they will lend more at home: either park the excess reserves in assets perceived to be risk-free (such as gold, safe-haven currencies, even banknotes though these would imply holding/warehouse costs). This would support the devaluation of the euro
  • Ultimately banks will reduce deposits with the ECB and start lending more at home only if they perceive that lending makes sense from a commercial stand-point, it is unlikely that they will do it for technical reasons. The experience of Denmark shows that the actual impact on growth from negative deposit rates was negligible. Note that this was not the reason why they did it. They were forced to act because of the peg with the euro.

2. On the quantitative easing front, the measures are specifically targeted at supporting actual lending to the private sector (excluding housing) which is a novelty in monetary policy around the world. Because they are by nature directed towards a specific market, these measures should have a positive impact on lending, as previous programmes worked for sovereign debt instruments. However, it is very hard to know when they will start having an impact on the real economy. Finally, if these measures have the desired effect, it remains unclear whether the impact will last the maturity of the programme, i.e. September 2018.

3. Overall, what seems to be clear is that these measures should have a significant impact on the exchange rate, thereby supporting inflation. Though the exchange rate is not a target in itself, it is, as acknowledged by President Draghi, has had an important dampening effect on inflation, namely through oil and food prices. These measures should allay some of the “deflation” fears related to euro strength.

The impact on actual lending is less obvious (the effect from quantitative easing should dampened by negative deposit rates) and it will take time to know whether it is successful or not. In any case, a positive impact is to be expected simply from the effect these measures may have on business and consumer confidence levels in the euro area.