For too long, the European Central Bank (ECB) has been long on promises and short on delivery. This month, however, ECB President Mario Draghi announced a five-step program of action, which - although limited in size, excludes bond purchases and may require further enhancement - is nevertheless in Draghi's phrase "significant." Will it be enough to end the threat of eurozone deflation? Not in my view.
Here's my take on the plan's five steps:
- Interest rate cuts to the main refinancing and marginal lending rates will probably not achieve much on their own. Rates are already so low that the small changes in their levels won't ignite loan demand. Banks are already risk averse, and loan demand is weak. However, imposition of a 0.1% annual charge on all banks' deposits in excess of reserve requirements could induce some banks to lend. Importantly, President Draghi acknowledged that interest rates had "for all practical purposes reached the lower bound," implying they couldn't be lowered further.
- New targeted long-term refinancing operations are the heart of the program. Banks will be allowed to borrow from the ECB, initially 7% of their total loans outstanding on April 30 to the euro-area nonfinancial private sector, excluding loans to households for house purchases. So the scheme is "targeted" at all business lending, not just small and medium-sized businesses, and deliberately excludes lending for home purchases.
- De-sterilization of Securities Market Program bond purchases, in effect, amounts to an injection of new funds - potentially as much as €216 billion - into the market, but the exact amount and the period over which the injections will be maintained has not been specified. Nevertheless, this is a real boost to liquidity and, in my view, should have been implemented two or three years ago.
- While extension of fixed rate, full-allotment tender procedures for main refinancing operations to at least December 2016 doesn't increase the ECB's funds on offer, it does reduce uncertainties and risks involved with the bidding procedure at ECB auctions and is therefore designed to increase the confidence of banks bidding for such funds.
- The ECB will intensify preparatory work related to outright purchases of asset-backed securities, which would directly create new deposits in the monetary system (if purchased from nonbanks) and expand the eurozone's money supply. This is exactly what is required.
Deflation threat remains
In my judgment, this five-point plan is a good step forward, but the ECB is still too politically and legally constrained to be able to do the right thing promptly. In reality, money and credit growth in the eurozone is far too low and needs to be substantially raised if deflation is to be avoided. Sadly for the present, the prospect of ECB purchases of asset-backed securities - or any other kind of securities -will remain only a possible option, and implementation can't be counted on.
More than a year ago, I forecast weak domestic demand in the eurozone resulting ultimately in deflation. My forecast has not changed: The threat of deflation in the eurozone remains.
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