The ECB cuts but will have to cut again

A shock rate cut last night is too little, too late for the eurozone. A deflation driven downward spiral in inflation is the last thing the region can afford, so expect more drastic action from the ECB.

In an unexpected move the European Central Bank (ECB) lowered its cash rate overnight, but the decision does little to improve the outlook for eurozone economies.

The ECB surprised most analysts overnight by cutting the interest rate on refinancing operations by 25 basis points to 0.25 per cent. They also cut the rate on their marginal lending facility (or emergency lending facility) by 25 basis points to 0.75 per cent. Despite the surprise, it was a much needed rate cut and lowers their cash rate to the level it should have been for several years now. Unfortunately, a single rate cut will be insufficient to ease Europe’s woes.

The cut was driven by increasing fears of deflation in the region after eurozone inflation slowed to 0.7 per cent over the year to October. Although lower prices sound great in theory, deflation can create a downward spiral, as consumers and businesses begin delaying purchases in anticipation of lower prices in the future. It also has the effect of increasing the value of debt, which would only deepen the pain from austerity measures in the eurozone.

Higher inflation on the other hand lowers the real interest rate (roughly nominal interest rate minus rate of annual inflation). Deflation effectively raises the real interest rate that consumers and businesses can borrow at, reducing investment and encouraging saving. The risk of deflation in the broader eurozone is remote, but for specific countries the concern is very real.

The ECB anticipates that inflation will remain at a low level in the coming months. On the basis of the inflation outlook, and the depressed broader economy, the ECB should cut rates to zero per cent at their next meeting.

However, the reality is that one or even two cuts to the ECB cash rate will do little to reverse the fortunes of European economies. The real interest rate is still well above the level required to boost domestic demand. The cut will not encourage banks to lend to households or businesses, which have grown by 0.3 per cent and -2.7 per cent over the year, respectively.

Earlier this week the European Union said that the unemployment rate in the eurozone will remain at around 12 per cent until the end of 2015. Recent data has also been far from encouraging; in addition to falling eurozone inflation, German industrial production fell by 0.9 per cent in September, while retail sales declined by 0.6 per cent across the region.

The German industrial production result is the concerning one, as a slowing German economy will drag down the broader eurozone economy. The recovery – such that it is – in some eurozone economies is fragile at best and even a minor shock to the German economy could be enough to push them back towards recession.

Earlier this week I discussed the subdued domestic demand in Germany and that German authorities could and should do more to support domestic growth (Germany is the self-centred Euro king, November 5). The idea that Germany should boost government expenditure is not a popular one, but the reality is that it is not practical for all major governments in the region to reduce spending simultaneously – particularly given the limited policy options available to governments in the eurozone. Germany is one of the few eurozone economies that can boost government expenditure and by doing so they could improve not only their economy but those of their neighbours as well.

The ECB cut, while welcome, will do little to ease the woes in the eurozone. The region will not be able to support a proper recovery until labour cost differentials are reduced (an internal devaluation) and the structural rebalancing of the European economy is complete. This process is a slow and, at times, cruel one. Perhaps when that process nears completion the low cash rate will promote a faster recovery.

Unfortunately, ECB policy is far too blunt to accelerate this structural rebalancing and as long as these imbalances persist the outlook for the eurozone remains bleak. The ECB’s best bet right now is to try and drive inflation higher, thereby reducing real interest rates but I fear that the ECB remains stubbornly anchored to their target of below, but close to, 2 per cent annual inflation.

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