2 Cheers For Mr. Draghi

Includes: ERO, EUO, FXE
by: Desmond Lachman

One has to applaud European Central Bank's (ECB) very quick interest rate response to the most recent inflation numbers that revealed a rapid rate of deceleration in Eurozone inflation. However, one has to be concerned that Mr. Draghi, the ECB's President, seems to be underestimating the very real risk of European deflation, especially in Europe's highly indebted periphery. One also has to question whether the ECB is doing nearly enough to avert that deflation risk from materializing.

The ECB's decision this morning to cut its policy rates by 25 basis points is clearly a step in the right direction. At a minimum, it should reduce disinflationary pressures by helping to weaken the Euro. Before getting carried away by this move, however, one should ask whether a 25 basis point cut in policy rates is nearly enough to get the European economy moving again. One also should question whether it will do much to reduce European unemployment from its present record level of 12.2%.

There are two reasons to be particularly skeptical about whether the ECB's latest moves are nearly sufficient. The first is that, by Mr. Draghi's own admission, the European monetary transmission mechanism is broken. Corporations and households in the European periphery continue to pay considerably higher interest rates than their counterparts in Europe's core countries. This suggests that that the periphery is benefiting very little from the ECB rate cuts.

The second reason for skepticism is that the ECB has now begun an asset evaluation exercise of the 130 major European banks that is to be completed by end-2014. And it is doing so without first ensuring that the banking system is adequately capitalized. This exercise threatens to exacerbate the European credit crunch already underway by incentivizing European banks to reduce their balance sheets in anticipation of the results of the ECB exercise. This would seem to be the very last thing that a struggling European economy needs now especially at a time that it is still engaging in budget austerity.

To put the this morning's modest ECB move into perspective, it is well to recall how Mr. Bernanke responded in September 2012 to a stuttering US economy and to a decline in inflation to below the Fed's comfort zone. He responded by having the Federal Reserve launch a third and open-ended round of quantitative easing on a unprecedentedly large scale that has already resulted in more than US$1 trillion expansion in its balance sheet. By contrast, even as European inflation falls to 0.7%, or to around one-third of the ECB's inflation target, and even as much of the European economy remains depressed, Mr. Draghi responds with a 25 basis point cut in interest rates. And he gives little indication that more ECB action is in the pipeline.