ECB Risks Not So Balanced
At today’s meeting the Governing Council of the European Central Bank (ECB) kept the interest rate on the main refinancing operations of the Eurosystem at 1.00%. In our assessment, ECB President Trichet appeared less at ease during the conference call that followed. This may well be a reflection of the realization that the economic recovery may take longer, require more action and such actions may cause as many problems as they solve. To put up a brave face, Trichet said the risks to the economic outlook are "balanced" – the codeword to suggest no major policy initiative to ease or tighten. Here are the positives mentioned:
- possibly stronger than anticipated effects from the stimulus measures taken, as well as
- a potentially stronger than expected recovery in confidence.
Compare that to the potential negative surprises:
- Concerns over a stronger or more protracted negative feedback loop between the economy and financial markets;
- further increases in oil and other commodity prices;
- an intensification of protectionist pressures;
- increasingly unfavorable labor markets; and
- a disorderly correction of global imbalances (meaning: a sharp plunge in the U.S. dollar or related currency crisis).
To us, this laundry list does not exactly look "balanced". In that spirit, Trichet does not expect a return to positive economic growth until the middle of 2010.
Just recently, the ECB provided €442 billion (about $620 billion) to the euro banking system at a fixed 1% with 12 months maturity; despite this massive injection, the money does not seem to be flowing from the banks to businesses. It’s a classical problem of central banking: you can provide all the liquidity you want, but there is no guarantee that banks will want to lend or that consumers and businesses want to borrow. In the U.S., the Fed is trying to avoid this problem by lending directly to consumers through its "credit easing" programs; the ECB has mostly abstained from credit easing as, amongst others, subsidizing consumers and non-financial businesses is not monetary policy and ought to be the responsibility of Congress/European state parliaments. In our assessment, credit easing programs are also counter-productive because central banks replace rather than encourage private sector participation as the central bank purchases increase security prices to levels no longer attractive to rational buyers (conversely, it lowers the yield, hence the attractiveness to consumers/businesses that have access to a cheaper cost of borrowing).
As the ECB feels the pain of its more stoic approach to monetary policy, it has started to blink. Today the final details are announced of its "covered bond" purchase program, call it credit easing light. The ECB is tip-toeing with policies that may result in it going down a path similar to that of the Fed. It’s our assessment that the ECB hopes that a recovery will come sooner rather than later, so that it may not need to expand this program. Unfortunately, as we have pointed out many times, hope is not a strategy and the ECB would be well served to steer clear of what we consider ineffective, inappropriate, and ultimately, a political minefield.
The recovery in the eurozone, according to the ECB’s own assessment – and we agree -, is likely to take longer than in the U.S.; the key difference, however, is that when the eurozone recovers, the damage done to budget deficits and the central bank’s balance sheet is likely to be far less severe in the eurozone than the U.S. That will only be achieved if the discipline the ECB preaches to its member states is also applied at its governing council.
Axel
Axel Merk
Author of Sustainable Wealth
President and Chief Investment Officer, Merk Investments
