September 12, 2019
The European Central Bank (ECB) met the market’s expectations Thursday in Mario Draghi’s swan song as the head of the central bank. The central bank cut its deposit rate by 0.1%, going further into negative territory, and restarted quantitative easing, in which it will purchase 20 billion euros in bonds monthly to help lower interest rates and inject liquidity into the financial system. The ECB also announced a tiered system to ease the pressure of negative rates on banks, exempting them from paying for the “privilege” of parking cash on some funds.
While these moves are bold, the central bank may have passed the point of diminishing returns, where each stimulus move has less incremental impact.
“The benefits of further monetary policy easing in Europe appear largely exhausted,” said LPL Financial Chief Investment Strategist John Lynch. “Lackluster economic growth in Europe will probably continue despite the ECB’s best efforts, and fiscal policy coordination may be required for meaningful progress.”
We would posit that the results from the ECB’s efforts have been mixed, based on these criteria:
- Is economic activity picking up? Economic growth in Europe has been slowing for almost two years now. We can’t pin this on the ECB, especially given drags on growth from trade and geopolitical uncertainty, but it seems it isn’t helping much.
- Is inflation rising? Inflation in Europe remains well below the ECB’s 2% target despite the extraordinary monetary stimulus put in place. Inflation in Europe is below 1% by some measures, and inflation expectations remain stubbornly low. The ECB cut its inflation forecasts today.
- Have borrowing costs for consumers and businesses fallen? Rates on consumer and business loans have fallen by about 2 percentage points over the past five years, but they’ve largely held steady over the past two years. Rates on consumer loans are still 5%, nowhere near the negative interbank lending rates, while corporate borrowing rates have fallen below 3%.
- Are banks still lending? Lending has grown in Europe at a respectable 4% level (Source: Capital Economics, Refinitiv). However, European financials have significantly underperformed the broad European equity market in recent years, based on the MSCI Europe indexes, reflecting the difficult interest rate environment. The ECB provided some relief for banks by exempting some funds held on reserve at the ECB from negative rates.
- Is the currency weakening? The euro has declined steadily over the past year as the European economy has weakened and interest rates have plunged. The risk is that engaging in a potential currency war may draw the ire of President Trump.
Today’s ECB moves are bold. While dependence on central bank actions is uncomfortable, markets appear to like it. Longer term, we remain concerned about the risks of unwinding quantitative easing and negative rates. We maintain our cautious tactical stance toward international developed equities, including Europe.
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