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Making decisions in a complicated Europe

July 10, 2013

Recently, mixed signals from the U.S. Federal Reserve have kept world markets guessing. Add uncertainty surrounding the long-term intentions of the European Central Bank (ECB) and the Bank of England, and markets face a complicated landscape. We asked our chief European economist, Peter Westaway, to explain the state of monetary policy in Europe to help you make informed decisions.

Are global markets right to fear that the Fed is about to tighten policy?

Peter WestawayThe Fed has hinted at slowing the rate at which it buys assets. In other words, it will carry on adding stimulus, but less quickly than before. So it's talking about stimulating less quickly, not tightening yet. In that sense, markets may have overreacted somewhat. But we're in uncharted territory with these unconventional policy measures, so market volatility shouldn't be surprising.

Is the ECB at a similar stage in its monetary policy setting?

Yes, if we acknowledge that the Fed is still providing stimulus, then the debate around the ECB is also about when and whether more stimulus should be added. But unlike the Fed debate, no one is talking about the ECB tightening yet. Remember, it was only in May that the ECB cut its headline policy rate to a record low of 0.5%.

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And there is a debate among commentators and even between ECB Governing Council members on whether they should go further. Arguably, there's a good case for this, because, according to the ECB's own mandate, the ECB's inflation forecast for euro-area inflation is well below its 2% ceiling at the two-year horizon, at around 1.3%. So there would seem to be scope for more stimulus.

But aren't there a few positive signs in the recent euro-area data?

Yes, the most recent forward-looking indicators are slightly more promising, notably the June purchasing managers' indices and the European Commission confidence indices. But this is still relative to a very weak growth backdrop. The ECB expects Eurozone GDP to fall by 0.6% in 2013 and, within that, GDP is not expected to have a quarter of positive growth until the fourth quarter. Growth in 2014 is expected to be 1.1%.

So why is the ECB reluctant to go further?

As other central banks have concluded, there are practical complications if policy rates are taken literally to zero. So at 0.5%, they may now be close to the effective zero boundary. But if the bank were to cut rates further, it's likely that it might then also take the step of charging negative interest rates on the funds that commercial banks deposit at the ECB. This would have the advantage of encouraging euro-area banks to channel their funds back into the interbank market, thus stimulating bank lending again, rather than holding funds at the ECB. It might also cause the euro to lose value, also helping to boost growth. But some ECB policymakers have warned of unforeseen consequences of such a move, so, in our view, the likelihood of such a step is small, for now at least.

What else might the ECB do to stimulate the economy?

One problem for the ECB is that the transmission mechanism of monetary policy is not effective in many parts of the euro area, especially the periphery. So whatever the level of the ECB policy rate, firms and households find it difficult to borrow. One recent proposal being actively considered is for the ECB to promote a market for asset-backed securities collateralized by loans to small firms (small- and medium-size enterprises). The ECB might also consider accepting such loans in its liquidity-providing repurchasing operations with banks, offering a strong incentive for banks to undertake this type of borrowing.

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Why doesn't the ECB take a lead from the Bank of Japan (BoJ) and launch full-scale quantitative easing (QE)?

The BoJ would certainly appear to have taken a radical step, but prices have been static or falling for at least a decade in Japan, so the scope for additional stimulus there was even greater. And asset purchases by the ECB wouldn't be straightforward because of the range of government bonds that it might buy.

There would seem to be no particular need to drive down yields on German and French bonds even further. But any attempt to make unconditional purchases of periphery bonds would cut across earlier commitments to make any such intervention conditional on the countries concerned, following the appropriate policies of fiscal consolidation and structural reform. So it's hard to see how exactly the ECB would implement QE.

So, overall, how long until interest rates get back to normal?

This is the 64 thousand pound, euro, or dollar question for bond markets. Certainly, we should expect interest rates to rise eventually, and it could be in the next couple of years, especially in the U.S. or the U.K. However, it could easily be more distant, maybe even ten years, before the process of financial deleveraging is complete and hence before interest rates return to more usual levels.


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