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Economy

ECB springs a surprise, but will it work?

Economic excitement in global markets is currently centered on the European Central Bank's decision on March 10 to ease monetary policy and conditions significantly. The ECB's announcements and the reaction in the markets will have been closely followed by the Bank of Japan, which is also pursuing negative interest rate policies and rapid quantitative easing.

     The rest of Asia will also have watched with interest because of the impact of the ECB's actions on the global equities, energy and commodities markets, even though the euro and the ECB play third fiddle to local economic developments and the U.S. dollar in China, India, South Korea, Taiwan and Southeast Asia.

     Even the most optimistic expectations about the ECB announcement were overshadowed by its decision. In effect, the bank's governing council decided by a large majority to throw the kitchen sink at the sluggish euro area economy and its very low inflation -- or mild deflation, judged by the 0.2% annual fall in the February consumer price index.

     The ECB announced that the negative interest rate on its main deposit facility, the charge paid by banks on their deposits at the ECB, would be changed from minus 30 to minus 40 basis points. (A basis point is one hundredth of a percentage point.) The volume of monthly bond purchases under the Asset Purchase Programme will be raised from 60 billion euros ($66.9 billion) to 80 billion euros a month -- from a total of roughly 775 billion euros at the end of February to about 1.8 trillion euros at the currently envisaged end of the program in March 2017. The ECB will also include investment-grade, non-bank corporate bonds in its asset purchases from June.

     The ECB's balance sheet, comprising asset purchases and other lending, is on course to expand to about 4 trillion euros by then, or about 40% of euro area gross domestic product. This proportion will be twice as big as the U.S. Federal Reserve's current balance sheet, but about half as big as that of the Bank of Japan by the end of this year. Nevertheless, the ECB and the BoJ will both have doubled the size of their balance sheets, or more, in the process of pursuing accelerated QE.

     One measure that few people expected was the decision to introduce between June 2016 and March 2017 four targeted long-term refinancing operation facilities with maturities of four years. These so-called TLTROs are loans to banks to help them bolster liquidity. For banks whose net lending exceeds a certain benchmark, the interest rate charged could be as low as on the deposit rate facility. In other words, the ECB will, in effect, pay banks to take the loans in the hope that this will encourage them to push out loans into the real economy.

     The ECB's monetary easing actions have to be set against its downgrading of the economic outlook. It lowered its growth forecast for the euro area from 1.7% to 1.4% for 2016, and more significantly lowered its inflation projections to 0.1% for 2016, and to 1.3% and 1.6% for 2017 and 2018 respectively. Stripping out energy prices, inflation was a bit higher at 0.7% in February. But the acid test of whether the ECB -- and BoJ -- strategies will work rests on their capacity to get companies and households to expect higher inflation, and to behave in such a way as to bring it about. So far, the evidence is unconvincing.

Counter-productive

In Europe, high unemployment is retarding higher investment and wages, as we might expect. In Japan, record high employment rates and rising female participation in the work force are not being reflected in higher investment or higher wages.

     For many, monetary policy -- and NIRP, in particular -- is not the answer. Central banks cannot force households and companies to borrow to spend and invest. Meanwhile, many observers, including the Bank for International Settlements, the central banks' central bank, worry that NIRP is counter-productive, and may even be an agent of falling inflation. Negative rates are thought to have adverse effects on bank business models, profitability, and loan volumes.

     Yet in the absence of new or different versions of economic thinking about what governments might do in key areas such as fiscal policy, public investment, corporate governance, competition and redistribution, the sole reliance on monetary policy will likely continue in Europe and Japan.

     After the ECB decision, bank shares surged, fell back and then rose again the following day. Equity markets were generally buoyant, as one would expect when a major central bank is throwing liquidity around. If a lower euro was an objective of the ECB, then this part of the strategy failed, as indeed it has for the Bank of Japan, whose NIRP and accelerated QE has seen the yen appreciate against the dollar from more than 120 to about 112. Charitably assuming that the central banks know what they are doing, we could argue that they are not trying to engage in covert currency depreciation, but greasing the credit channels in the economy so that commercial banks' balance sheets strengthen and enable them to expand credit into otherwise moribund economies.

     The acid test of whether this strategy is working should be rising bond yields. If unorthodox monetary policies are thought likely to spark higher economic growth, stronger credit, and eventually higher inflation, then bond investors should sell what are by any benchmark very expensive assets. But as we know, negative yields seem fairly well entrenched in major euro-denominated bond markets and the Japanese bond market. And at long maturities of 10 or more years, German and Japanese yields are what is called "very skinny" -- that is, close to zero. In the case of the ECB last week, it was notable that German government bond yields barely moved.

     For now, markets will make hay, but the true test of whether the monetary strategy is working will be in the bond markets. For Asia, the focus, as always, is principally on the U.S. bond market and the U.S. dollar, rather than Europe and Japan. The US economy may not be in great shape, but quarter by quarter it seems to be churning out economic growth at an underlying pace of 2%. The Fed has realized a very low unemployment objective and may be starting to see its inflation objectives fall into view. It is still early days, and the March Fed meeting is expected to come and go without a further rise in policy rates.

     This will come as a relief to Asia, since it should help to keep the dollar relatively subdued. Stable U.S. interest rates and an unexciting path for the dollar would be welcome for as long as they last.

     

George Magnus is an economic consultant and associate at the University of Oxford China Centre.

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