Time for the ECB to step up to the plate

IT came as no great surprise last Thursday that at the end of its monetary policy meeting, the ECB cut official interest rates by 0.25% for the second month running.

This brought the key refinancing rate back down to 1%, fully reversing the two 0.25% rate hikes implemented earlier this year in April and July. This reversal of policy was triggered by the sharp slowdown in economic activity over the course of 2011.

The last eurozone recession ended in mid-2009 but the subsequent recovery in activity looks to have been moderate and short lived. Growth in GDP has averaged at less than 0.5% per quarter over the past two years and exceeded 0.4% in only two quarters.

The recovery did pick up strength in the first quarter of 2011, with GDP rising by 0.8%, but it lost momentum again in the second and third quarters, with GDP growing by just 0.2% in both quarters. The economy continued to lose momentum in recent months.

It now seems very likely that the eurozone economy has re-entered recession in the final quarter of the year. Unemployment has also been rising since mid-year, with the jobless rate reaching 10.3% in October. Inflation has been stuck at 3% in recent months, which is well above target.

The expectation is that the sharp economic slowdown will exert downward pressure on inflation, helped also by lower oil prices. This should see the HICP (Harmonised Index of Consumer Prices) rate fall sharply in 2012 to comfortably below 2%.

The latest ECB staff quarterly economic projections published last week also reflect the changing landscape. Yet again, they contain appreciable downward revisions to the growth forecasts. GDP growth for 2012 is now seen at 0.3%, down from 1.3% and 1.9% in September and June, respectively. GDP growth for 2013 is forecast at 1.3%. The ECB staff made slight upward changes to their 2011 and 2012 inflation forecasts.

The HICP is forecast to average 1.5% in 2013.

The weakening economy is only one of a number of serious problems facing the ECB. The ECB is being forced to inject massive amounts of liquidity into the money markets and provide term funding for banks. It announced last week further measures, easing collateral requirements for repo operations, extending the maximum repo term from 13 months to three years for two repo operations, and cutting the reserve ratio from 2% to 1% which will free up more collateral.

There were no hints though from the ECB about further rate cuts, but neither was there any confirmation that rates have troughed.

Despite the rates cut, the ECB press conference was again largely dominated by the ever deepening euro sovereign debt crisis. There have been repeated calls on the ECB to intervene in bond markets in support of countries such as Italy and Spain and act as a buyer of last resort.

ECB president Mario Draghi, though, was quite clear that monetisation of government debt by the ECB is not permitted by the EU Treaty, either directly or indirectly by lending to the IMF for this purpose.

This came as a blow to markets ahead of the EU summit last Friday and left many wondering if a deal to safeguard the eurozone can be achieved without a more active role by the ECB. With official rates now at 1% but 10-year bond yields in many eurozone countries at very high levels, the ECB’s monetary policy transmission mechanism is clearly less than perfect.

This would seem to constitute strong grounds for the ECB to intervene with large-scale bond purchases to ease this problem, i.e. not as a buyer of last resort or to monetise debt but for quantitative easing to put downward pressure on long-term yields.

Otherwise, monetary policy is ineffective in lowering borrowing costs in many eurozone countries that badly need easier monetary conditions, notably those where fiscal policy is being tightened most.

John Beggs, chief economist AIB