ECB offers cheaper money despite reactions from Germany

European Parliament, Committee on Economic and Monetary Affairs (ECON) meeting. Hearing with Mario Draghi, European Central Bank President but also as Chairman of the European Systemic Risk Board. (EP Audiovisual Services).

Yesterday, the European Central Bank, in a swift move, reduced its basic interest rate to 0.25% from 0.5%. The decision was taken by the Governing Council of the bank, in its regular meeting which takes place on the first Thursday of every month. This decision has reportedly taken the capital markets by surprise, but this is not a fair criticism.

One month ago Mario Draghi, the President of the central bank, in his introductory remarks after the October meeting of ECB’s Governing Council, had pointed out that the Council follows developments with ‘increased vigilance’. Given that inflation fell in October below 1%, this ‘increased vigilance’ was almost tantamount to an interest rate reduction.

On top of that, yesterday Draghi reminded everybody that “These decisions (the reduction of interest rates) are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%”. Only some days ago Eurostat, the EU’s statistical service, announced that according to its flash estimate, the October inflation was as low as 0.7%. In view of that, the ECB had to act.

What the markets want or what is right?

The much-advertised by mainstream media surprise, that the markets experienced with this ECB decision, is related more to their ‘want’ than the objective reality. For one thing, all the major financial groups of Eurozone, led by the giant insurance companies of Germany, reacted negatively yesterday evening, after this ECB decision was announced. In reality, this was not a surprise move by the ECB but rather an unwanted by the capital markets one, but necessary for the real economy development.

It was the least the ECB could do to counter Eurozone’s dangerous disinflation trend, which may evolve into deflation, a possible forerunner of a return to recession. Greece’s five year deep economic decline has brought about negative inflation (deflation) since last March, with Spain recently joining the club and Italy moving fast towards zero price changes. This is a good enough reason for ECB to offer cheaper money, despite the outcry by the huge German financial groups.

Theoretically, any decrease of interest rates will reduce the incentive to save, increase the propensity of households to consume and raise the investment expenditure of businesses, by undercutting their borrowing cost. Of course in this case the 0.25 reduction in ECB’s interest rate is rather marginal and it’s questionable if it will reach the lending rates of banks. Let alone that bank loans balances to the non-financial business sector have been falling for years now.

What is right for the real economy?

However, the ECB appears ready to continue on its growth support policies, with further reductions of interest rates and other measures. Draghi clearly said that “the Governing Council…continues to expect the key ECB interest rates to remain at present (0.25%) or lower levels for an extended period of time. This expectation continues to be based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy and subdued monetary dynamics”. A few minutes earlier he had also observed that, “Such a constellation suggests that we may experience a prolonged period of low inflation”.

It’s not only the prospect of even lower interest rates that has unnerved Eurozone’s financial markets though. They are also afraid that the ECB may soon pass from the presently zero, to negative interest rates, for the money deposited by banks to the central bank. This will act as a strong kick from the ECB to banks, in order for them to start increasing again their financing to the real economy, instead of keeping their money parked with the central bank, avoiding taking the slightest additional risks in the real world.

No matter what Germany says

At this point it must be explained that the central bank act as the bank of banks, accepting their deposits of idle money. The interest rate on those placements is zero since 11 July 2012. All along this period the zero returns to those deposits didn’t act as an incentive for the banks to increase their financing of the real economy. The problem has taken unbelievable dimensions in the south of Eurozone, with the bank loan balances to households and SMEs falling steeply. In the core Eurozone countries things are different with adequate financing available on demand for everybody.

To reduce this fragmentation of Eurozone’s financial markets, the ECB is intensifying its efforts. Draghi also stressed that “We are ready to consider all available instruments”. He explained that the central bank will take positive measures on all refinancing operation fronts and noted that there are still €730 billion of MROs (main refinancing operations) and LTROs outstanding (longer-term refinancing operations).

In short, the ECB seems to be ready to exhaust its mandate and abilities to intervene in support of the real economy, despite the negative reaction of Germany. This time it was the wealthy German giant insurance companies awash in cash, which opposed the reduction of interest rates. Yet the ECB didn’t back off from that. Actually Draghi revealed that the decision was not taken unanimously and everybody understood who had voted ‘no’. The European Sting has been pointing out for quite some time, that inflation is dangerously decelerating, encouraging the ECB to take action.