Nearly two years ago, European Central Bank (ECB) President Mario Draghi, who is the euro-zone’s counterpart to Fed Chief Janet Yellen, said the central bank would do whatever it takes to preserve the euro. He added for emphasis, “Believe me, it will be enough (Bloomberg).”
His bold statement was enough to attract investors back into Spanish bonds, which at the time were on the brink of default. Today, yields on longer-term Spanish bonds are at a record low (Bloomberg).
A default by Spain would likely have been followed by serious tremors in the troubled nation of Italy, which sports the world’s third largest bond market (Financial Times). It’s a too big to fail, too big to bail out scenario that would have threatened much or all of Europe.
But what troubles Europe today is not the immediate threat of a debt crisis. Instead, it’s a rate of inflation that has fallen to a dangerously low level; just 0.5% versus one year ago (Eurostat). For comparison purposes, the U.S. Consumer Price Index increased at a year-over-year rate of 2.0% in April, per the latest BLS data.
Falling prices may sound appealing at first glance, but it’s a dangerous downward spiral that’s best avoided. Once a deflationary psychology takes hold, some might decide to delay purchases amid expectations of even lower prices.
That in turn could quickly throw an economy into a recession, further depressing the price level. It’s akin to an economic black hole. A look at Japan’s experience over the last two decades is a sobering example.
The ECB cut its key lending rate from 0.25% to a record low of 0.15%. More importantly, it cut its deposit rate, or the rate banks earn on their reserves, from 0% to -0.10%. It’s the first time a major global central bank has implemented a negative rate. In addition, the ECB announced targeted measures that are also designed to encourage lending and modestly boost cash in the financial system.
What it did not do is launch a controversial Federal Reserve style bond-buying program, though Draghi did hint that more measures may be in the offing. "Are we finished? The answer is no. If need be, within our mandate, we aren't finished here (ECB transcript of the press conference),” Draghi said.
Draghi is the master of rhetoric, able to craft just the right statement at just the right time. On the flip side, I might add that the German press was dismayed by the new measures, lamenting that already low interest rates on savings could go even lower (Wall Street Journal).
Note: the fed funds rate is targeted by the U.S. Federal Reserve. It is included for comparison purposes.
The ECB has several objectives in mind. Encourage lending by placing a small penalty on excess reserves. It would also like to weaken the euro by making the currency a less attractive place for investors to park funds because a weaker euro should raise the price of imports and support inflation. It also makes exports more competitive, aiding a weak and fragile economic recovery.
Will it work is another matter. A reduction in its key rates by just 0.10 percentage points is not enough to fix what ails its economy, as the opportunity cost not to lend went by just a fraction of one percent. But the psychological impact may be more important, and Draghi’s insistence that we may see even more aggressive measures got the attention of Wall Street.
Importance to U.S. investors
As the Federal Reserve is gradually reducing its rate of bond purchases, which has slowed the U.S. rally this year, Europe may be set to launch its own version. The possibility new cash may pour into the global financial system encouraged bullish sentiment.
The result: both the Dow Jones Industrial Average and the broader based S&P 500 Index claimed another record high (Wall Street Journal). It also lent support to the recent rally among the riskier smaller-company stocks, which have taken a modest beating in recent weeks.