An ECB rate cut would be no magic wand
–Darren Williams is Senior European Economist at AllianceBernstein. The opinions expressed are his own.–
Disappointing April data suggest that the European Central Bank is set to cut the refinancing rate at Thursday’s Council meeting. This is likely to have limited economic impact but could encourage expectations of more creative policy action later, helping to take some upward pressure off the euro.
At its last Council meeting in April, the ECB said it stood “ready to act” after delivering a downbeat message on the euro-area economy. Since then, most of the survey data have tended to confirm the message delivered in March: that improved figures at the turn of the year were a false dawn and that the recession is likely to extend into the second quarter. With few indications that the economy is about to emerge from its protracted slumber and inflation pressures dormant, there is now a compelling case for an easing of monetary policy.
The good news is that most ECB Council members probably agree, making a 25 basis point reduction in the refinancing rate likely at Thursday’s meeting. The bad news is that these Council members also seem to think that a rate cut won’t make much difference. Why?
There are two main reasons. First, interbank interest rates are already close to zero and are thus unlikely to be affected by a reduction in the refinancing rate. Second, as indicated by the historically low level of real interest rates in the euro area, ECB policy rates are not the main problem at present. Rather, it is the transmission of those rates to households and firms in the periphery.
But these are not valid reasons for inaction. Even if there are doubts about the efficacy of a rate cut, this doesn’t mean the ECB should sit back while the economy struggles to break free from recession. Nor is it true that such a cut would have no impact. It would, for example, lower the cost of borrowing funds from the ECB, with banks in the periphery likely to benefit most.
Moreover, a reduction in the refinancing rate would help counter market concerns about the recent contraction in the ECB’s balance sheet and encourage expectations of additional measures if the economy continues to languish. This, in turn, might help reduce upward pressure on the euro at a time when other central banks are continuing to ease monetary policy.
Nonetheless, we should be conscious of what the ECB can and cannot do. ECB Executive Board member, Joerg Asmussen, said recently that many of the unconventional monetary policy tools used in other countries—i.e. large scale asset purchases and forward interest-rate guidance—would either “not be very helpful” or are “not easily applicable” in the euro area.
So while a rate cut at Thursday’s Council meeting would certainly fuel expectations of more creative policy action at a later date, it is not obvious what such measures would look like or how quickly they would be implemented. One thing is clear, though: it’s unlikely to be soon.