On the 1st of January 1999, the ECB assumed responsibility for monetary policy in the euro area, with the primary objective of maintaining price stability, keeping the euro area’s target inflation rate (calculated using the Harmonized Index of Consumer Price, HICP) below, but close to 2% over the medium term. This objective has even been reinforced with the ratification of the Lisbon Treaty in 2007. Seventeen years later in 2008 the global financial crisis erupted causing the greatest economic recession since 1928. Since then the ECB has been put under additional pressure to advise on regulation and enforce banking supervision while fostering economic growth. Extremely unconventional monetary measures have been taken to achieve this objective and a recover of the economy and productivity.
On the 12th of November 2008, the first measure was implemented by cutting the interest rates for deposits, overnight loans and the Main Refinancing Operations. The two main objectives of this move were to provide greater liquidity to commercial banks and depreciating the currency against the US dollar, allowing a greater competitiveness.
Despite the large amount of capital lent through MROs and LTROs, banks preferred to buy bonds instead of lending to families and enterprises, not fulfilling their function as middleman between the ECB and the real economy.
On the 26th of July 2012, Mario Draghi famously announced that the ECB was willing to do “whatever it takes”. Consequently, launching new measures to support the countries, which were facing economic and financial difficulties. In September of that year the Outright Monetary Transactions (OMT) were introduced.
The OMTs key points were: Unlimited ex-ante bonds purchase quantity; one-year and three-year maturity bonds purchase; transactions performed in the secondary market sterilizing the exceeding liquidity. While this programme was initially controversial, as it questionably occurred outside of the ECB’s legal framework, it did achieve its expected outcomes, as bond yields in the weaker countries declined. On the 5th of June 2014, the ECB announced the first series of TLTROs (Targeted Long Term Refinancing Operations) which linked the amount borrowed and lent (expected mortgages) to private sector, aiming to incentivize banks to increase their lending.
Although the ECB had implemented all these unconventional measures, no significant positive effect had been seen. The PMI index evolution show a soft recovery ignited by Draghi’s first moves.
That is why on 22nd January 2015 Mario Draghi introduced an extended Quantitative Easing program, the Asset Purchase Program (APP), which allows the purchase of Eurozone government bonds. This programme allowed for € 1,140 billion in bonds to be purchased and lasted 19 months (supposedly, from March 2015 to September 2016), injecting even greater liquidity into the market. The bond purchases provided greater monetary stimulus to the economy while the key ECB interest rates were kept at their lower bound. Furthermore, an easing of monetary and financial conditions occurred, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately aims at helping the economy reach its targeted inflation rate. This move was unexpected from market who rejoiced vigorously, pushing European stock indexes up to multiyear highs. DAX index, the one who benefited the most from the ECB’s new plan topped 12000 points.
After one year of the extended QE program some doubts arose about the effectiveness of the ECB’s monetary policy, raising the credibility of monetary policy issue and igniting criticism from some member states, such as Germany, mainly for the negative impact on people’s savings.
In response, the ECB surprised the markets in March 2016, by cutting key interest rates, expanding the asset purchase program to 80 billion monthly and deferring the end to March 2017. In addition, the percentage of bonds that can be purchased has changed from 33% to 50% and the purchase program includes also some high-rated companies’ shares other than covered bonds and asset-backed securities. Four new TLTROs (TLTRO II) are being issued every three months, starting from June 2016 with an interest rate, which is linked to the participating banks’ lending patterns. The more loans that participating banks issue to non-financial corporations and households (except loans to households for house purchases), the more attractive the interest rates on TLTRO II borrowings becomes.
In a recent statement at the ECON committee of the European Parliament on the 28th of November, Mario Draghi remarked that: “To increase the effectiveness of monetary policy, fiscal and structural policies are needed that reinforce growth and make it more inclusive”, while in his speech ten days before, stated that “Since the onset of the global financial crisis, 2016 has been the first full year where GDP in the euro area has been above its pre-crisis level. The economy is now recovering at a moderate, but steady, pace, while the employment is growing. We remain committed to preserving the very substantial degree of monetary accommodation, which is necessary to secure a sustained rise in inflation.” Despite Draghi’s reassurances, as well as the unconventional and largely expansive measures carried out by the ECB, one can observe that inflation levels are rising, but still at a too slow pace, currently at 0,5%. The same can be said for GDP growth.
The main question to ask is where is large amount of capital that is being injected into the economy flowing, and why is it not boosting growth?
Low interest rates – the rate on the deposit facility is -0.4% while the interest rate on the main refinancing operations is at zero level – should decrease the cost of financing of the banks and lower the attractiveness of government bonds inducing them to lend to enterprises and consumers. Unfortunately, many factors have contributed obstructing the transmission of money to the real economy and restrained the banks from granting loans. First, the banks are not inclined to lend money for three main reasons: the poorer margins on loans, squeezed by the rates at their lowest level; the necessity to keep risks under control which conflicts with the credit standards’ tightening, particularly on corporations, that can even be worsened by the forthcoming introduction of Basil IV, still under discussion, which is considering to impose the use of standardized credit scoring approaches, instead of the more flexible Internal Standards-Based Approach introduced by Basil II, change which will require higher provisions for risks; at last the harsher capital requirements set by Basil III in 2013, which induce banks to immobilize funds that could be alternatively lent.
It seems that the situation is getting better and banks are finally increasing the amount of loans granted. It is noticeable that the increase is faster since 2015, year of introduction of the Quantitative Easing program. The manufacturing PMI Index for euro area, which measures the performance of the manufacturing sector, is climbing up to the 2011 peaks. Therefore, the introduction of stricter credit rating approaches is highly questionable and more flexibility should be given to lenders.
It is also true that the low interest rate policy and the Asset Purchase Program have contributed to the increase in prices of assets and so the reduction of yields, inducing banks to take greater risks in return for higher returns. Indeed, fixed income prices are at their highest while the German 10Y bond yield is only 0,2%, having been even negative last June for a couple of months.
Another reason behind the lack of effectiveness of the quantitative easing is that it could not have the impact desired, as interest rates at the inception of the program were already very low. The 3-months Euribor rate was hardly higher than zero.
The conclusion is that monetary policy does little to support growth, when not combined with adequate fiscal and regulatory policies. The IS-LM diagram, or Hicks–Hansen model, can help one better understand the current situation. Last but not least, the world today is in what can be deemed as a “liquidity trap”. A situation in which the central banks cannot reduce the interest rates even further, as doing so has no effect on inflation. Policymakers are pushing negative interest rate policies to stimulate growth. Lower rates are designed to spur savers to spend, redirect capital into higher-return (i.e. riskier) investments, and drive down borrowing costs. This is associated with a weaker currency, making exports more competitive. When a “liquidity trap” occurs and rates go negative, a squeeze on the speed at which money circulates through the economy, commonly referred to as the velocity of money, incurs. Therefore, each Euro generates less and less economic activity, increasing deflationary pressure. As consumers see prices decline, they defer purchases, and growth slows. Deflation also lifts real interest rates, which drives currency values higher. If the ECB persists in this policy, pumping more and more liquidity into the economy, then more negative rates could be on the way.
The austerity measures pursued by the European Union since the beginning of the European sovereign debt crisis at the end of 2009, have constrained the member states to lower their debts and the public spending, exacerbating the fiscal policy and worsening the economic downturn. By the way, it seems that, under the more insistent demand by many member states for more flexibility, EU is overshadowing the pursuit of lower deficits, to focus on the boost of economic growth.
On the 8th of December 2016, Draghi announced that the ECB would scale back the monthly bond purchases from € 80 billion to € 60 billion in March 2017, postponing the end until December 2017, reassessing the support of ECB to markets. Moreover, the ECB would consider (but not necessarily pursue) purchases of bonds with yields below the standing facilities deposit rate (i.e. -0,40%), thereby incurring losses for the central bank, if such purchases were to be made. This announcement provided a largely positive reaction on the European equity markets, while European bond market yields fell even lower and the Euro/Dollar had its largest drop since Brexit, depreciating by 1.5%. Following the announcement of the ECB’s future QE plans, reporters repeatedly questioned whether and when tapering would occur and Draghi insisted that members of the governing council unanimously did not consider such measures.
Europe, to help the ECB to fulfill its task, is considering several non-monetary measures. The Capital Markets Union (CMU), strongly supported by ECB, is expected to come into effect in 2018. Commercial banks are currently hesitating to issue new credit, particularly to SME’s – which account for 99% of all enterprises in EU – due to the size of their large balance sheets. The CMU would enable commercial banks to shift risks away from balance sheets by allowing investors (such as pension funds) to invest in securitized loans. However, it must be stringently regulated, to ensure that the quality of the debt being securitized and sold, meets certain standards. A lesson tragically learned by the recent financial crisis.
The harmonization of fiscal policies among EU member states seems still far away and hard to achieve. At last Europe is changing attitude in direction of a greater allowance for deficit spending and public debt, under the requests received by many member states, which questioned the austerity policy.
Unconventional and expansionary monetary policies have been implemented by the ECB in the past years in response to one of the greatest recession in history. The traditional policies are no longer effective and the Central Bank is now experimenting new solutions, which are contributing to the recovery, even if the results are not as good as expected and Europe has not recovered the pre-crisis economic level yet.
European bodies and the ECB are struggling to boost the economy and to increase the cohesion within the European boundaries through a process of continuous change.
However, many are the threats to the future of Europe. The forthcoming elections in France, Germany and perhaps Italy, on the wave of anti-European and nationalist movements, are likely to increase the uncertainties about the solidity and cohesion of the Union, even more after the stunning result of Brexit referendum. Cohesion that is already under pressure and exasperated because of the different interests and views of the member states about serious issues currently under discussion such as the actions to adopt in response of the massive migration wave that is hitting EU borders (and that can even worsen given the current tragic situation in Syria) or the necessity of austerity policies.
Second, the possibility that the extremely expansionary measures can lead to excesses and to a financial bubble likely to explode once there would be a tightening of the policy (house prices in healthier countries are rising sharply).
Furthermore, the effects of the enhanced divergence between the monetary policies pursued by the ECB and the Fed are still unknown and unforeseeable. The Fed has not surprised investors with the last adjustment on December, even if the signal sent by Janet Yellen was little more hawkish than market is used to. The immediate effect has been a strengthening of the dollar against other currencies and a sell-off European bonds, which showed a rise in yields. The Fed funds futures show that traders are now betting on a faster tightening by US Central Bank. Indeed, the Chairman has announced that there will be at least three more adjustments in 2017. It seems that the era of ultra-low yields is nearing its end in USA, where the economy is recovering strongly and even better are performing the financial markets (Wall Street has reached its historical peaks).
The effects for Europe are difficult to predict, but for sure, the quicker the dollar strengthens, the more destabilizing that is. For instance, a huge amount of emerging countries’ bonds is issued in dollars, thus it would be harder to repay it Moreover many commodities are priced in dollars so they would become much more expensive contributing to a slowdown of global economic activity that depends on the consumption of such resources, on the oil price, which is now recovering after having hit its lowest level at the beginning of 2016.
The ECB is dealing with a testing challenge: achieve a recovery of the European economy and productivity within a global environment characterized by slow economic activity and great uncertainties, while experimenting policies never pursued and whose results are difficult to predict. The difficulties and the threats that can obstacle the fulfilment of the mission are many, so are the opportunities that can be taken. There are too many uncertain factors that make useless and speculative every effort to make predictions. Draghi, which will be in charge until 2019, seems to have clear ideas about how to deal with the task and has already achieved very good results, despite the critics.
Would the ECB and EU bodies be able to face the forthcoming hard times, keeping the EU unity and cohesiveness and achieving finally the economic recovery? Stay tuned.
Conor Marriman, Niccolò Ricci and Alessandro Sicilia