ECB in disarray and about to hit the panic button on rates

The odds are rising too that the bank will step up its 1 trillion quantitative easing programme

PUBLISHED : Sunday, 15 November, 2015, 12:28pm
UPDATED : Sunday, 15 November, 2015, 12:28pm

The last thing markets ever want to see is a central bank in public disarray. When its handling of the economy comes into question, it is a bad omen for financial market stability and confidence in its currency begins to suffer. Investors tend to run a mile from uncertainty.

Right now, the European Central Bank (ECB) seems in deep trouble and it is putting euro zone markets and the euro in jeopardy. The euro zone economy could easily slip back into recession, deflation risks abound and high unemployment poses a real danger to European political stability.

Judging by recent public outpourings, the ECB may be about to throw caution to the wind and hit the panic button with another deposit rate cut as early as next month. The odds are rising too that the bank will step up its ¤1 trillion (HK$8.3 trillion) quantitative easing (QE) programme. Time is running out fast.

Last week’s third quarter gross domestic product data showed the hallmarks of an economy getting into deeper trouble

The crisis is coming to a head. The inflation outlook has weakened again and there is scant chance of the ECB hitting its 2 per cent inflation target for a long while. Deflation problems are not the only worry, as the euro zone economy is quickly losing forward momentum, thanks to lacklustre domestic demand and the global economic downturn.

Last week’s third quarter gross domestic product data showed the hallmarks of an economy getting into deeper trouble. Quarterly growth slowed to 0.3 per cent, or 1.2 per cent at an annualised rate, far too low to save the economy from the lingering effects of debt deflation and austerity. The euro zone needs much faster escape velocity to reach sustainable growth and faster job creation.

Even Germany’s economic powerhouse is losing steam. Slower export demand and the downturn in manufacturing orders and industrial production are clear signs that Germany is in for tougher times ahead. If the spillover from China’s economic slowdown and the downturn in emerging economies gets any worse, recession will return to haunt Germany.

This should provide the ECB with enough ammunition to act next month. But the trouble is it already has its foot jammed hard to the floor, leaving little extra scope for the monetary accelerator. A marginal cut in the ECB deposit rate will hardly make much difference, while the economy is already showing signs of QE exhaustion.

The only thing the ECB can do is go for ‘overkill’ and hit the market with a bombshell of extra bond buying, raising recovery and inflation expectations in one fell swoop. This would probably require the ECB’s current ¤1 trillion QE programme to be doubled, setting the scene for the bank’s balance sheet to explode to around ¤4 trillion in the next couple of years.

Something exceptional needs to be done, but it is questionable whether the ECB has the imagination and pluck to carry it out, especially with Germany’s ultra hawkish Bundesbank breathing down its neck.

Given the magnitude of the problem it is no surprise the euro is bearing the brunt. The currency seems hell-bent on a crash dive back towards parity against the US dollar at some stage soon. The threat of more rapid monetary debasement will hit the currency hard. But this is no bad thing.

The ECB is hardly going to stand in the way of the weaker euro. Benign neglect of the currency will do a huge favour for euro zone exporters by helping to boost flagging trade demand.

All is not lost, but new solutions will be needed beyond the ECB’s ambit. The euro zone is in desperate need of new policy initiatives involving fiscal reflation, fuller budgetary integration and a co-ordinated regional development plan to complement the ECB’s monetary stimulus programme.

Euro zone governments can stop the rot but they need to start working together in a more effective fashion. Austerity policies must be set aside until stronger growth gets back into gear. Full European fiscal union must be fast-tracked to ensure a much more equitable spread of economic prosperity and productive capacity throughout the euro zone.

Resources of the richer euro zone nations need to be channelled into putting the poorer economies into much better economic shape. Until this happens, widening economic disparities will deepen the growing political discord between the euro zone haves and have-nots.

The challenge for Europe’s policymakers will harmonising monetary, fiscal and currency policy to build a better future and avoid a dangerous slide into deeper economic degradation.

David Brown is chief executive of New View Economics