Yet another cut in Interest Rates

 Lawrence Zammit's article on The Times of Malta

At last week’s press conference following the meeting of the board of the European Central Bank, Mario Draghi, its President, announced measures that reflect a yet more accommodative monetary policy than hitherto and to support lending to the real economy. These measures include further reductions in the key ECB interest rates, targeted longer-term refinancing operations and preparatory work related to outright purchases of asset-backed securities.

What all this implies in simple layman terms is a more loose monetary policy by the European Central Bank to draw out the Euro zone economy from its current state of fragile economic growth.

In practical terms, the interest rate on the main refinancing operations (which is sued as a reference rate by the Euro zone banking system) has been reduced to 0.15%. The deposit rate for monies deposited with the ECB is now at -0.10%. So now banks have to pay for depositing money with the ECB. The ECB shall also be supporting bank lending to consumers (excluding house loans) and to businesses.

However it is worth asking why the ECB is taking this stance. The prospects of the Euro zone economy still show modest growth and a disparity between the member states. Estimates for real GDP growth for 2014 have been revised downwards to 1%. On the other hand estimates for 2015 have been revised upwards to 1.7%. Growth in the first quarter of 2014 was at just 0.2%.

This indicates how fragile the Euro zone economy still is. The average figure also hides the fact that some economies have had interesting growth rates, while others are still experiencing significant negative rates – hence a disparity between member states. Moreover the inflation rate target is still 2%, while the current rate of inflation is 0.5%. 

On the other hand, with a such a low inflation rate, it would seem that the ECB and the Euro zone economyare caught between a rock and a hard place. The current low inflation rate should motivate consumers to spend more and should encourage investors to invest more. Yet this has not happened, to the extent that the ECB has felt it should be even more accommodating in its monetary policy.

The value of the euro is not helping either. With its current high value (even if it has gone down in the last few days) compared to the US dollar, it has meant that imports from non-Euro zone countries are cheaper while exports to non-Euro zone countries are more expensive. As such investors become less willing to invest. For one reason or another, there appears to be an expectation that the inflation rate will go down even further and such an expectation leads to a disincentive to consumers to spend.

So what does not seem to be working? Why hasn’t consumer spending taken off with such low interest rates? Why haven’t the business sector perceived the current low interest rates as an opportunity to invest more? How can current economic growth be given more substance?

I believe that the main reason for a lack of significant take-off of the Euro zone economy is that governments of the Euro zone have still not sent a clear message about their priorities. It is still not known which policy line will be adopted – is it a policy aimed at stimulating growth in income and employment or will it be a policy aimed at continued fiscal consolidation.

The evasive answer is that governments should aim for a balance between both policies; but no one has as yet come out with measures of how to achieve this balance. Until the Euro zone governments agree on their respective fiscal policy, it is difficult for monetary policy to leave the desired effects.

There are also conflicting signals in relation to banks. The ECB is pushing banks to lend more. However the new rules for the European Banking Union are putting pressures on commercial banks to manage their loan portfolios more prudently.

Maybe we also require a change in mindset. Prior to the first wave of the international financial crisis of 2008, economic policies were developed on the premise that people behave rationally and one could anticipate certain forms of behaviour given a certain set of circumstances. This premise no longer seems to apply. Do economic policy makers need to lay less emphasis on numbers and more emphasis on human behaviour, which is still characterised by a large dose of emotionality? The technocrats can only do so much; the real answers have to come from the politicians.

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