Blog | Personal Finance

The ECB Is Worried and It Should Be

meet your own rich dad - start your quiz now

The ECB Is Worried and It Should Be

The economy of the Eurozone is barely growing. The size of the economy is still 2% smaller than it was before the crisis of 2008 struck. The unemployment rate is 11.7%. Bank lending continues to contract. Now, deflation is becoming a growing threat. Prices rose just 0.5% in May compared with one year earlier. Moreover, the ongoing economic hardship in Europe is fuelling a powerful political backlash that threatens to tear the entire European integration project apart. Anti-European Union parties gained a shocking number of seats in last month’s European parliamentary elections.

On June 5th, the European Central Bank (ECB) announced an aggressive package of policy measures designed to encourage banks to lend in order to kick-start the economy and to prevent deflation from taking hold in the Eurozone area.

1. It cut its official lending rate by 10 basis points to 15 basis points (i.e. effectively 0%).

2. It announced that it would begin to charge banks 10 basis points for any excess reserves the banks held at the central bank.

3. It offered to lend up to Euro 400 billion to the banks at very low interest rates for four years if the banks agreed to relend that money to small and medium sized businesses. Importantly, it specified that loans for mortgages or to governments would not qualify for the low rates offered in this program.

4. Finally, the ECB stated that it was considering buying asset-backed securities (a form of Quantitative Easing) and that it would take even more aggressive steps if necessary (a hint that it could even begin to buy government bonds the way the Fed and the Bank of Japan are doing).

Will these measures be effective? Here are my thoughts:

Cutting the official interest rate by 10 basis points (#1) will have no impact whatsoever. Those rates were already extremely low. Consider QE (#4) is not introducing QE. Talk is cheap. The market wants to see action. If the ECB did begin QE, it would cause the Euro to fall and that would help the economy grow by boosting exports. It would also reduce the chances of deflation. “Considering it” is not the same thing as doing it.

Charging the banks 10 basis points on the deposits they hold as excess reserves with the ECB is an important step. This is the first time a major central bank has imposed “negative interest rates” on bank reserves. Let’s think about this. Banks are always eager to lend money, but only to people and companies capable of paying the money back. The reason the banks have deposited so much cash with the central bank is because there are no additional creditworthy borrowers. So, now the banks will have to decide whether they will lose more than 10 basis points by lending the money. If they would lose more than 10 basis points, they will simply pay the ECB 10 basis points. That way they will lose less. It will be very interesting to see which choice they make.

The third measure has the best chance of success. This measure will reward the banks for lending by offering them the opportunity to borrow money from the ECB at very low interest rates at a fixed rate for four years. It is a variation on the Bank of England’s Funding For Lending Scheme, which has been effective in boosting lending in the UK. The difference, however, is that under the ECB’s plan (which it calls Targeted Long Term Refinancing Operations, or TLTRO) mortgage loans do not qualify, whereas in the UK they do. This is interesting because it shows that the ECB is not willing to drive economic growth by inflating a new property bubble, whereas that is exactly how the Bank of England has orchestrated the rebound in the UK economy. It will be interesting to see whether TLTRO will be effective. The problem remains that there are just not any additional creditworthy borrowers out there.

The ECB has hoped that the announcement of these measures would cause the Euro to weaken relative to the US dollar. In the days leading up to the ECB press conference, the Euro did, in fact, weaken from 1.39 to the dollar to as low as 1.35. However, on the day of the announcement, it actually rebound to 1.36. This must have come as a disappointment for the ECB. It looks to me as though that disappointment will deepen over the weeks and months ahead, as the Euro could very possibly strengthen further from here.

ECB President Mario Draghi said he did not expect these measures to show meaningful results for three to four quarters. By that time, it is quite possible (even probable) that the Fed will have backtracked on its plans to end Quantitative Easing in the US. The market has been led to believe that US QE would end by the fourth quarter of this year. If it does not (and I believe that it won’t), then the dollar will weaken significantly from here; and that means the Euro will rise. If things play out this way, then the ECB will have to do more than just consider printing money and buying assets, it will actually have to do it.

Take advantage of these Free Rich Dad tools.

Original publish date: June 09, 2014

Recent Posts

Unlocking Wealth Secrets
Personal Finance

Unlocking Wealth Secrets: Strategies for Financial Mastery

"Actions speak louder than words." Discover why it's important to pay attention to what investors like Warren Buffett do, not what they say.

Read the full post
investing in green energy
Commodities, Personal Finance

Investing in Green Energy: Here’s How to Profit

The world has been slowly transitioning to clean energy sources... but it’s about to hit the accelerator. Discover how to profit from the future... now.

Read the full post
Rich Dad’s Guide: The Difference Between Sales and Marketing
Entrepreneurship

Rich Dad’s Guide: The Difference Between Sales and Marketing

If you want to see your business grow, it’s time to focus on marketing as part of your sales funnel.

Read the full post