ECB poised to act … modestly

May 2, 2013

It’s European Central Bank day and we have it on very good authority that a quarter-point interest rate cut is on the cards, which will take rates to a record low 0.5 percent. A plunge in euro zone inflation to 1.2 percent, way below the target of close to but below 2 percent, has cemented the case for action.

In terms of reviving the euro zone economy this is pea shooter and elephant territory. The ECB has consistently diagnosed the key problem that already ultra-low interest rates are not transmitted to high debt corners of the euro zone, where lending rates are much higher and credit restricted. A rate cut won’t change that. It also illuminates the gulf in approach with the Bank of Japan and Federal Reserve who continue to print money at a furious rate.

The Fed said on Wednesday it would continue buying $85 billion in bonds with new money each month and added it would step up purchases if needed to protect the economy, dousing recent suggestions that the programme could be wound up in the months ahead. Nonetheless, a euro rate cut will help at the margins.

The ECB is also considering ways to help small- and medium-sized companies get easier access to credit. This is a thorny debate. There is clearly some internal opposition and even disinterested outsiders say it is an unusual thing for a central bank to get involved in. Don’t bet on it happening.

The really interesting point is that if the ECB fears deflation could take hold, all the arguments about what its mandate allows it to do (one reason it has not mimicked the Fed, BoJ and Bank of England in printing stacks of money) fall away and all sorts of expansionary policies are possible. If that fear doesn’t gain traction, then the ECB is reaching the limits of its policy response unless it gets an excuse to launch its bond-buying programme, which seems a distant prospect at the moment.

That the euro zone economy could do with a sharp prod is not in much doubt. Euro zone PMI manufacturing surveys today are unlikely to give much cause for celebration. We’ve already had flash readings for the currency bloc as a whole plus Germany and France which registered an alarmingly poor reading for Europe’s largest economy. Today we get a look at the performance of the likes of Italy and Spain which will presumably be even worse.

All that adds fuel to the austerity versus growth debate. New Italian premier Enrico Letta is touring Europe demanding a new focus on economic stimulus though he also says Italy will meet its debt-cutting targets. Having not got much change out of Angela Merkel, yesterday he won French backing from President Francois Hollande and today is likely to get the same from European Commission president Barroso who has declared austerity has reached the limits of popular support. But it’s Germany as the EU’s paymaster that counts, not Italy and France.

Slovenia’s planned bond issue had to be pulled at the last minute on Tuesday after Moody’s downgraded its credit rating to junk. But the game is back on and the bond may launch today as the realization dawned that investors are desperate for yield. German 10-year debt pays 1.2 percent, the same as the inflation rate so offers no real return over a decade. Before the Moody’s bombshell, the issue had attracted about $12 billion euros for a $3 billion issue that would have funded the country for up to a year. That may well still come to pass, though probably at a somewhat higher cost now, and buy enough time to address the billions of bad loans swamping Slovenia’s banking sector without requiring a euro zone bailout.

Local government elections take place across Britain, which are traditionally a moment to kick the government of the day and this time is likely to be no exception. The biggest worry for the ruling Conservatives is how far the anti-EU UKIP eats into its vote and that could have profound implications. David Cameron has promised to negotiate a repatriation of power from Brussels – a venture he is unlikely to succeed in – and offer a referendum on EU membership thereafter. If UKIP is eating his lunch, the pressure from the mass of eurosceptics in his Conservative party to head towards the European exit door will go up another notch.

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