Has Europe’s Monetary Policy Gone Down the Rabbit Hole?

At the beginning of May, the European Central Bank announced that it would lower the interest rate on both the marginal lending facility and main refinancing operations within the Eurosystem. Effective May 8, the rate on the marginal lending facility decreased by 50 basis points to 1.0 percent, and the rate on main refinancing operations decreased by 25 basis points to 0.50 percent. The interest rate on the deposit facility remained unchanged at 0.0 percent.

“These decisions are consistent with low underlying price pressure over the medium term. Inflation expectations for the euro area continue to be firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2 percent over the medium term,” commented ECB in its May 2013 Monthly Bulletin.

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The most recent inflation data released by Eurostat, the statistical office if the European Union, showed that the annual inflation rate in the EA17 is expected to decline from 1.7 percent in March to 1.2 percent in April. Gains were led by food, alcohol, and tobacco prices, which increased at an annual rate of 2.9 percent, followed by services with a 1.1 percent increase. Energy prices fell 0.4 percent.

Euro Area all-items HICP, annual rate

Source: Eurostat

“In keeping with this picture,” continued the ECB in its monthly bulletin, “monetary and loan dynamics remain subdued. At the same time, weak economic sentiment has extended into spring of this year. The cut in interest rates should contribute to support prospects for a recovery later in the year.”

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Economist sentiment, as measured by the European Commission’s ESI index, fell 1.5 points in the euro area to 88.6, and fell by 1.8 points in the EU to 89.7. Expectations for future economic activity have been trending well below the long-term average, indexed at 100, since about 2011.

European Economic Sentiment

Source: European Commission

Perhaps most troubling is that sentiment worsened significantly in major economies such as Germany (-2.3 points), France (-2.0 points), and Italy (-1.9 points). These declines echo bad news gleaned from other reports such as the Markit Eurozone Composite PMI, which showed that overall output in the region has declined over the past 15 months.

“Against this overall background,” the ECB commented, “the monetary policy stance will remain accommodative for as long as needed. In the period ahead, the Governing Council will monitor very closely all incoming information on economic and monetary developments and assess any impact on the outlook for price stability”

This commitment to accomodative monetary policy is not necessarily a new development, but it’s emphasis in the public dialog is. The policy had its beginnings in Mario Draghi’s pronouncement that he would do whatever it takes to ensure the unity of the currency bloc, and was emphasized in a policy statement on May 2. Much of the language in the ECB’s May 2013 bulletin was sourced from same statement.

Looking ahead, European officials remain hopeful that economic growth will return to positive territory by the end of 2013. Real gross domestic product has declined for five consecutive quarters, punctuated by a 0.6 percent contraction in the fourth quarter. Overall labor market conditions remain weak, with the unemployment rate in the EA17 edging up to 12.1 percent in March, and remaining flat at 10.9 percent in the EU27. Both measures are up more than 1 full percentage point on the year.

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Eurozone Unemployment by Region

Source: Eurostat

“In the meantime,” Draghi said in the May 2 policy statement, it is essential for governments to intensify the implementation of structural reforms at national level, building on progress made in fiscal consolidation and proceeding with bank recapitalisation where needed. Furthermore, they should maintain the momentum towards a genuine Economic and Monetary Union, including the swift implementation of the banking union.”

To put it lightly, the idea of a banking union has been something of a hot-button issue in the EU for the past couple of months. European authorities have grappled with the paradox of needing to wind down illiquid banks without having a formal mechanism to do so. Draghi and the ECB have previously championed the formation of a banking union, which would possess the means and authority to handle the thankless task, but the idea has received opposition from Germany.

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Wolfgang Schäuble, Germany’s finance minister, has expressed concern that unless some sort of “network” for liability is set up, Germany will continue to be on the hook for banks, stating, “[If] we mutualize liability without fully mutualizing the decision-making power, we create the wrong incentive again. Therefore we’ll have to get by with a network in the first stage, or focus on a network, as long as we haven’t created further institutional improvements.”

In light of this opposition, EU leaders have put a new idea on the table: creating authority within the European Stability Mechanism or the European Commission itself to wind down faltering banks. If measures were taken to allow the EC or the ESM to handle failing banks, existing EU treaties would be able to remain unchanged, which could be appealing to Germany as they look to avoid being further financially obligated for euro zone banks.

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