ECB rate cuts won’t cure the Eurozone’s lowflation problems
Rate cuts are finally here. The European Central Bank (ECB) has announced its decision to ease monetary policy in the Eurozone through a package of expansionary measures. It has decided to cut the bank’s main refinancing rate by 10 basis points from 0.25% to 0.15%, and to lower the deposit rate into negative territory, from zero to -0.10%. This makes it the first major central bank to charge financial institutions for their deposits.
In theory, negative deposit rates should encourage business lending as they force financial institutions to search for more rewarding uses of their cash reserves. However, the level of bank deposits held at the ECB may simply be too low to stimulate much lending. European banks’ deposits with the ECB have fallen sharply since the height of the crisis and currently stand below €30bn, compared to above €700bn in mid-2012. Even if all of this pot goes into more lending, it will do little for growth. What we may see instead is deposit flight as savers look for banks more willing to take on their cash elsewhere, as happened in Denmark when the central bank moved deposit rates into negative territory between July 2012 and April 2014. This in turn could even lead to a fall in lending, making the rate cut effectively contractionary, and do little to raise Eurozone inflation.
We continue to believe that low inflation in the Eurozone is more of a symptom than the real disease. For periphery countries, it simply reflects their strive to improve competitiveness in a monetary union, as the lack of ability to adjust the exchange rate forces them to devaluate internally. This effectively means lowering costs and wages, which consequently lead to lower prices. At first sight, this seems totally desirable. However, inflation is low even in Germany, the region’s strongest and largest economy. Because of Germany’s dominant position in the region, German disinflation feeds through into low overall Eurozone inflation, forcing the competitiveness-seeking periphery into deflation. This shifts the focus from low overall Eurozone inflation to the question of what is driving the disinflationary trend in Germany.
Germany’s strong current account surplus, and the lack of domestic demand is certainly one factor at play. This can only be corrected through an increase in German consumption, or expansionary fiscal policy in Germany; culturally and politically a big ask. The other explanation rests with the exchange rate: The strength of the euro puts downward pressure on German inflation because of Germany’s high export dependence. A depreciation of the euro could thus act as remedy to curtail disinflationary forces in Germany, by making imports more expensive and raising export competitiveness.
For this reason, it is precisely through the exchange rate where today’s ECB decision will have the greatest effect. The Danish experience certainly sets a good precedence for negative deposit rates’ ability to help bring down a currency’s exchange value. A weaker Euro will certainly be welcome by German exporters. It is less clear whether the squeezed households of the European South will be as glad to see their energy bills increase as a result.