At the next European Central Bank (ECB) policy meeting in September, it is expected to gently lower interest rates to ease the burden on a stagnant Eurozone economy. However, previous long-term Quantitative Easing (QE) measures, along with a prolonged period of historically low-interest rates calls into question the future ability of the ECB’s toolkit to reinvigorate inflation to its 2% target and defend against future shocks. This creates fears of structural issues within the ECB and the Eurozone.
Background to Eurozone stimulus
To stave off a Japan-style currency deflation during the Eurozone Crisis, the ECB initiated a bond-buying spree to shore up the Euro. It was immensely controversial within the Eurozone then, seen as bailing out of more profligate members of the club. Its QE policy purchased €2.6 trillion of assets from 2015, over a fifth of the Euro area’s GDP, until QE was wound down in December 2018. This produced many successful results, such as twenty-two quarters of continuous GDP growth as well as real wage growth. Wages rose at 2.5%, their highest rate in the first quarter of 2019 since 2009. However, the picture isn’t all rosy. The ECB now needs to wean the Eurozone economy off this expansive financial assistance amidst a gloomy economic and political outlook, while inflation sits at historic lows.
Future headwinds and the ECB toolkit
The Eurozone faces two major risks. First and foremost is the impending threat of the USA-China trade war. Europe is particularly vulnerable to the effects of future tariffs imposed by President Trump and Xi Jinping. Their economies are largely export-driven with extensive foreign direct investment and inter-woven supply chains across the continent. In 2017 goods and services exports accounted for 27.9% of Eurozone GDP, double the level of the United States. A global slowdown in the goods and services industry will hold severe ramifications for Europe. Such fears have been allayed by weak economic data this week, with an 8% fall in June exports in Germany, compared to the previous year. Some analysts fear Germany is heading for a recession, worrying news for the largest Eurozone economy. Crucially, Europe possesses little control of the direction and severity this trade war takes.
A second consideration is the reduced toolkit the monetary union has to shore up its defences and to battle a slowdown. Interest rates already sit at historically low levels with the main ECB refinancing rate remaining at 0%. Businesses have already had opportunity to take advantage of the masses of cheap debt swirling around the Eurozone. Banks are apathetic towards the prospects of lowering interest rates to negative yields as this will cut into their profit margins on loans and become costly to store their deposits with central banks. The governing council of the ECB also believes it has reached the “effective lower band” whereby the cost of future interest rate reductions will outweigh expansionary effects envisioned by negative interest rates.
Fiscal stimulus
After rate-setting, a fiscal stimulus is the crucial alternative resource. Another round of QE is widely anticipated, but here there are pitfalls: the ECB has imposed limits on the share of a country’s debt it can hold on to, currently, that sits at 33%. Analysts believe these limits mean further QE could only be sustained for an additional 12 months before exceeding such parameters. These limits could be altered, ECB president Mario Draghi has stated previously such restrictions possess an element of flexibility, but QE is an extremely controversial issue, with Germany being the main detractor.
Increasing these levels of sovereign debt ceilings will be, politically, a tough sell. Concurrently, QE faces legal disputes. A court in Karlsruhe, Germany, is hearing whether sustained QE amounts to ‘monetary financing’ which is banned by EU treaties. The claimants want Germany’s Bundesbank, the largest purchaser of assets under the QE programme, to stop participating in any further QE initiatives. Alternative stimulus suggestions include the ECB purchasing equities, rather than debt. The aim here would be to increase productivity and the demand for capital.
Draghi’s final stand at ECB
Outgoing ECB President Mario Draghi has a policy gathering of the governing council in September. With dark clouds looming in the form of a trade war, weak Eurozone data and a potential no-deal Brexit, expect this session to be utilised for the formation of a stimulus package.
In terms of interest rates, the ECB will take heed of Jerome Powell’s dovish decision at the Federal Reserve in July. A tentative 0.1% cut to its key deposit facility interest rate, currently sat at 0.4% is probable. Analysts also expect a return to bond purchases of around €50bn per month in a return to quantitative easing. At the very minimum it should offer reassuring forward-looking guidance that there is room for interest rates to be lowered in the future, should the current economic outlook remain pessimistic.
After Draghi’s departure, IMF Chief, and former France Finance Minister Christine Lagarde is expected to become the next ECB President. The start of her tenure will see the status quo of low-interest rates remain in place, to protect against the various threats to the Eurozone economy. The late-cycle of the economy, accompanied by trade protectionism, Brexit and a truculent debt-saddled Italy are all added complications at the start of her leadership. But perhaps her biggest fight will be over fiscal policy, notably in Berlin. Germany’s longstanding opposition to borrowing, its ‘debt brake’ poses questions on borrowing in times of need. Fiscal policy is a politically sensitive issue, but the ECB needs to create a unified form of stimulus for future times of trouble.
