Peter Krauth: European Central Bank President Mario Draghi is desperate.
The European Union has been plagued with years of falling inflation and stubbornly high unemployment.
And now its central bank is attempting to employ “unconventional” policies to kick-start the economy.
Using tactics never tried before, the ECB has just entered uncharted waters.
But if we look at the history, we’ll see the perfect opportunity to profit…
Europe’s Next Great Experiment Begins…
Last Thursday, after months of thinly veiled hints, the ECB took drastic measures.
Some of the central bank’s key moves included:
- Interest on main refinancing operations (MROs) was lowered by 10 basis points to 0.15%. These are loans to banks secured by sovereign debt.
- 400 billion euros were made available in loans to banks with a limit of up to 7% of existing loans to the nonfinancial private sector (excluding home lending).
- Marginal lending facility (overnight credit from ECB) was lowered from 0.75% to 0.4%
But the real kicker…
- Deposit rates (interest paid to banks on deposits at the ECB) were lowered from zero tonegative 0.1%. Banks will now have to pay the ECB to leave funds on deposit. This is exactly what I highlighted back in mid-April.
It’s a move no other major central bank, not the Fed, not the Bank of England, not even the Bank of Japan, has yet tried.
So what’s the goal, and will it work? As it turns out, we can gather clues from some precedents.
The Velocity of Money Is a Problem
The ECB is similar to the U.S. Federal Reserve in that it issues the official currency, the euro. It also sets interest rates to help guide the economy, and it supervises commercial banks. But its top job is to keep inflation under control. The Fed has similar goals, yet has a “dual mandate” that includes seeking low inflation and high employment.
So let’s look at the problems the ECB faces.
Europe’s been mired in a “low-flation” state since 2011, with inflation actually decreasing over the past two and a half years to 0.5% in May, considerably under the 2% target.
This can be a problem in that, if it goes on for an extended period, markets will begin to expect falling prices, or deflation. Those expectations can drive consumers to delay spending as they assume they can buy things for less in the future, thereby retarding consumption.