Intimations of central bank impotence

Comments from ECB chief Mario Draghi seem to confirm investor fears that central bank rate cuts are losing their kick. But policymakers have few other options to try.

As expected, the European Central Bank cut its key interest rate by a quarter point to a record low of 0.75 per cent, while the Bank of England decided to restart its printing presses and buy a further £50 billion ($US78 billion) in government bonds.

But the People’s Bank of China surprised investors by lowering its key one-year lending rate by 0.31 percentage points to 6 per cent, the second cut in less than a month.

Investors, however, have begun to fear that central banks are impotent in the face of the creeping paralysis in the global economy. Indeed, ECB boss Mario Draghi appeared to concede as much, telling a press conference that when businesses and households had very little demand for loans, the ECB itself could not boost lending to the real economy.

Investors also queried whether the Bank of England’s decision to restart its printing presses would help the recession-hit UK economy. Since the financial crisis hit in 2008, the bank has bought £325 billion in assets – mainly government bonds – in an effort to reduce long-term interest rates. It now intends to lift its asset purchases to £375 billion.

Critics, however, argue that the problem is that businesses, faced with a slump in demand, will remain reluctant to borrow no matter how low UK interest rates fall.

Similarly, investors worry that lower interest rates will do little to boost the Chinese economy, which is slowing due to dwindling demand for Chinese exports and a cooling property market.

They fear that the rate cut will do little to help Chinese exporters, which are facing a sharp slide in sales to Europe and the United States. And while the cut could conceivably help the country’s property developers, the Chinese central bank, the People’s Bank of China, took the unusual step of warning banks to "continue to suppress speculative investments in housing”.

Overnight this increasingly gloomy mood was reflected in a sharp drop in European stock markets, and a spike in Italian and Spanish borrowing costs.

Paris dropped 1.2 per cent, while Milan fell 2 per cent and Madrid dropped by almost 3 per cent as investors decided that the ECB’s rate cut would not prevent the eurozone debt crisis from worsening. At the same time, Spanish bond yields jumped to 6.7 per cent, while Italian bond yields climbed to just below 6 per cent.

Investors, deeply disappointed by the ECB’s impotence, have again started to focus on the eurozone’s next line of defence against its spiralling debt and banking crisis – its two bailout funds.

But here again, there is little room for optimism. Combined, the bailout funds only have €700 billion ($US867 billion) in firepower – of which €200 billion has already been committed to rescuing Greece, Ireland and Portugal. As a result, markets have already formed the view that the bailout funds are not up to the task of rescuing Spain, let alone Italy.

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