|Summary: The European Central Bank moved to cut official interest rates to near zero last night, while deposit rates moved into negative territory. The continuation of quantitative easing is aimed at a number of key objectives, including to weaken the euro.|
|Key take-out: The ECB’s latest move, along with actions by other central banks, will act to support property and equity markets for far longer than expected. The Australian dollar should rise and, with our economy stronger than thought, the key positive for investors is investment opportunities abroad will be reopened.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
It may not seem like it, but the European Central Bank’s latest decision is a game changer – it will materially alter the market outlook, not just for global markets but for Australia as well.
To see this let’s first consider what the ECB’s decision isn’t about. The ECB’s decision has almost nothing to do with the threat of deflation or fears over a weakening economy. That’s the press surrounding the decision: I see this. Yet even the ECB said itself that: “We don’t see deflation, or a self-fulfilling negative spiral of expectations … we don’t see households postponing their spending plans.”
The reason for the bank’s relaxed attitude was outlined by the ECB’s vice-president Vitor Constancio recently. He noted that 80% of the drop in inflation from 2011, when it spent much time above target, can be put down to global factors, like the fall in commodity prices. Moreover, inflation (currently at an annual rate of 0.5% annually) would actually be 0.5 percentage points higher without the appreciation of the euro. Two factors then basically explain Europe’s low inflation rate – currency appreciation and a fall in commodity prices. Neither of these is a structural phenomenon though – these are cyclical influences. It was less than a year ago that annual inflation was around target at 1.6%, and in the years prior to that inflation spent most of its time well above target. More generally;
- The economy is actually accelerating, and the Euro zone has experienced four consecutive quarters of growth following recession through 2011, 2012 and 2013.
- The price of money – already at record lows – wasn’t a problem in Europe. Business, prior to this decision, could already borrow at rates between 2-3%, as could households. Banks are already flush with cash, and so the supply of credit wasn’t a problem either. Demand for credit was the problem – but you can’t force individuals and business to borrow if they don’t want to, by providing banks with even more free money.
It’s no surprise then that most economists and commentators don’t actually think the measures taken last night will achieve anything – in terms of economic growth or inflation – and rightfully so, as they won’t. The measures, in the context of steps they’ve already taken, are meaningless for the economy at large.
The ECB changes
Take a look at what the ECB announced last night:
- A cut in the official cash rate to 0.15% from 0.25%.
- A long-term refinancing operation that will provide banks with all the money they want at 0.25% for four years.
- A ‘negative’ deposit rate, which is an economist’s way of saying that instead of paying banks to deposit money with them, they now charge them money – 0.1%.
So what is the ECB doing then? It is simply following a well-trodden path, cleared by the Fed and the Bank of England. Recall when the Fed first embarked on its QE program, deflation was the bogeyman – as it is in Europe now, supposedly. Yet as inflation accelerated in the US and growth picked up, QE continued and the program was ramped up – extended. In 2014, the Fed still prints money notwithstanding solid growth and employment outcomes – and an uptick in inflation. No, the truth is deflation fears have nothing to do with this latest decision. The way I see it, this was just an opportunistic play by the ECB with several goals in mind:
- Weaken the euro.
- Cover an apparent retreat from fiscal reform.
- Provide Euro zone governments with cheap finance and ready customers for government bonds (much of the funds provided to banks in long-term refinancing operations are used to buy government bonds).
- Shore up bank balance sheets.
- To a lesser extent, to be ‘seen’ to be doing something as well – e.g. IMF and the US, had been pressuring them to act.
This distinction is important, because if Europe’s monetary policy was aimed at growth and inflation, then we could be confident of a withdrawal, possibly a quick one later this year, once the danger zone was past. In good conscience no-one could possibly have this confidence now. The ECB’s long-term financing operations are in place till 2018 – and if anything, it has hinted at more stimulus to follow. That’s why it so radically changes the game plan.
An extension to quantitative easing
Think about it. Up until this point we were possibly looking at an unwinding of monetary stimulus in 2015 by the Fed, the Bank of England and maybe even the Bank of Japan. That is how things were playing out. Now, it will be that much more difficult for the Fed to extract itself from its own QE program – and not just the Fed. The central banks of England and Japan will also drag their feet – and that’s saying something. In Japan inflation is currently at a 23-year high. A lot of it is tax induced but inflation, aside from that, is still on the up. In Britain, economic growth is its strongest in seven years, employment growth is its strongest since the 70s, and house prices are surging.
The reason for that is simple. No country wants a strong exchange rate. If the US continues on its ‘tightening’ path the $US will surge. That’s not what happened last night – perversely the euro strengthened. Yet it won’t take long for markets to reverse that if ECB and Fed policies do actually diverge. Same with the British pound and the yen which, of course, is why any divergence is highly unlikely.
Implications for investors
There are three key implications for investors from all of this. Central bank polices will act to support property and equity markets for far longer than expected. I’ll go so far as to say that I don’t think the bull market is in any real danger of ending for the foreseeable future. Rate hikes from any of the major central banks in 2015 are unlikely at this point, and the world is awash with free money.
Another implication is that the Aussie dollar is likely to push markedly higher this year, and we got a taste of that last night. That’s not necessarily a problem though – in fact if policymakers can just remain silent for a change, and resist their usual confidence destroying rhetoric, it won’t be.
As investors found out this week, the Australian economy is far stronger than policymakers thought. The mining boom hasn’t ended – yet again – growth is at trend, exports are surging, the unemployment rate is falling and over 100,000 jobs have been created so far this year. House prices are pushing higher and there is still no sign of the supply shortfall being adequately addressed.
The key positive for investors is that this will reopen investment opportunities abroad – opportunities that some may have been unwilling to look at when the currency was weaker.