ECB: Super Mario Bros. 2 (Kitchen Sink Edition)

Andrew Mulliner, CFA, a Global Bonds Portfolio Manager, reflects on the European Central Bank’s decision to cut rates and bring back quantitative easing.

Key Takeaways

  • This week, the European Central Bank (ECB) revived its bond-buying program and, in a surprise turn, said the stimulus would be in effect until the central bank next raises rates – a timeline that could turn out to be indefinite.
  • The ECB also cut rates further into negative territory, eased lending terms for eurozone banks and shifted forward guidance to focus on an inflation target of near 2%, rather than a date.
  • The actions amount to the ECB throwing the kitchen sink at the eurozone economy, and consensus is growing that the next form of stimulus will likely need to be fiscal policy. The question: Will eurozone economies act decisively?

Expectations were high coming into the European Central Bank (ECB) meeting on Thursday in spite of press briefings by various hawks on the governing council rejecting the need for more quantitative easing (QE) in the eurozone. As has become ECB President Mario Draghi’s specialty, he managed to deliver a dovish surprise to markets in spite of clear reservations from some colleagues and, on paper, a relatively modest program compared to what some had hoped for or expected. However, as is often the case with regard to monetary policy, the devil is in the details.

ECB Throws Everything at the Eurozone Economy

While much of the speech followed the script set out by ECB observers in the run-up to Thursday’s meeting, the big surprise came with the announcement that the revived QE program of bond purchases should continue until just before the ECB next hikes rates, as opposed to the much shorter time period of nine months to a year that most had expected. Given the sclerotic condition of the eurozone economy, this promise to maintain QE until rates go up is as good as a QE forever. The parallels to Japan are clear.

Another focus of attention for investors was the cut in interest rates and the program of tiering the rate at which bank reserves are remunerated. The challenge for negative rates has been that, perhaps as far as the banks are concerned, the cure for low inflation (negative rates) may be worse than the disease. The measures put in place by the ECB are admittedly very technical and only time will tell if they are truly effective, however estimates are that the ECB has taken a measured approach. At the margins this will be beneficial to the banking community, however the drag on bank profitability remains.

The other actions were broadly as expected and potentially even on the stingier side of expectations. Deposit rates were cut from -0.40% to -0.50%, and the recently announced targeted longer-term refinancing operations (TLTROs) have been adjusted both in length and also in the form of incentives to banks to lend to the real economy, in terms of potential interest cost. This brings them closely in line with the last TLTRO operations and makes them more generous with it. Finally, forward guidance has shifted to focus on the inflation rate converging “robustly” to the target of close to, but below, 2%. This is compared to a date-based forward guidance which had gradually lost credibility as the ECB persistently missed its target. As ever, the ECB promised it could do more if required; however, we may wonder why doing the same thing over and over again should deliver different results.

Focus Turns to Fiscal Policy – Will It Be Enough?

The ECB has thrown the kitchen sink1 at the eurozone economy once again, and we will have to see if it works. It was notable, however, that when asked about the unanimity of the governing council on these decisions, the only point of unanimous agreement was that fiscal policy needed to take the lead from monetary policy. Investors agree. The challenge is that, while we are seeing eurozone economies, including Germany, stepping in this direction, is there sufficient will to act as decisively as the ECB has been prepared to do?

With Christine Lagarde on her way in as ECB president, Mario Draghi on his way out and a new European Union Commission president soon to be in place, the chess pieces are being positioned for a shift to fiscal stimulus. The question we ask is, will they be willing to do whatever it takes?

1“Throwing everything but the kitchen sink” at a problem means using almost everything at one’s disposal. Throwing the kitchen sink, therefore, means using all the options one has.