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November 18, 2013

Economic Update

By By Brendan Circle '14 & Heidi Zhang '14  |  november, 2013, Issue 2
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The big international economics story last week was the surprise rate cut from the European Central Bank (ECB) that came a month earlier than expected. The main lending rate was cut from 0.50 percent to 0.25 percent, 75 bps lower than it was at the height of the financial crisis in Autumn 2008. Eurozone inflation in October slowed to just 0.7 percent, a significant drop from the 1.1 percent in the prior month, and the slowest rate of inflation since the 2009 global slowdown. Decelerating inflation is a Eurozone-wide issue and is occurring across all expenditure components. Given the ECB's inflation target of 2.0 percent, the weak inflation figures forced the hand of ECB President Mario Draghi.

In addition to the front-and-center problem of inflation, the ECB is also wrestling with how to stop the decline in bank lending. Loan growth in the Eurozone has been negative for the better part of the past year and a half. The rate that the ECB pays banks which keep loans on deposit with the central bank was left unchanged at zero. There has been some speculation that Draghi might begin charging commercial lenders for keeping loans on deposit. A penalty rate, or negative deposit rate, might incentivize banks to lend more. Together with the rate cut, the ECB did extend its three-month Long-Term Refinancing Operations program (providing easy credit to banks to bring down borrowing costs) until at least mid-2015, which is potentially aimed at avoiding some unpleasant risks for Eurozone banks further down the road.

The ECB has so far been quite successful with its communications strategy. Since Draghi announced that the ECB would do "whatever it takes" to save the Euro, sovereign spreads have remained under control without too much additional ECB intervention. For example, the threat to purchase Eurozone counties' secondary sovereign bonds through the Outright Monetary Transactions (OMT) program has yet to be used because the market believed the threat. However, communication alone may not be enough as the Eurozone is only just emerging from recession while the U.S., U.K. and Japan have been enjoying mild expansions. As the ECB showed last week, it is now taking action instead of only using words to give more credibility to their "forward guidance," or central bank communication aimed at signaling the likely future path of policy rates, which in the ECB's case would be a loose monetary policy.

Last Updated 11/19/13
Last Updated 11/19/13