EUROPEAN Central Bank (ECB) officials agree that lower interest rates are needed to buoy the region’s shaky economy. How much they can actually help, though, is hotly contested.
Some policymakers urge rapid cuts to encourage consumers to spend and businesses to invest. Others are more cautious, deeming challenges including high energy costs and a dearth of skilled workers to be beyond the remit of monetary policy.
Who prevails will help determine the end point for an ECB easing campaign that’s set to deliver a fourth quarter-point reduction in the deposit rate on Thursday (Dec 12). With inflation largely defeated, investors are betting that dovish arguments will next year guide borrowing costs to levels that are likely to stimulate economic activity.
“Views in the Governing Council differ over how much of the current economic weakness is cyclical and how much is structural,” said Holger Schmieding, chief economist at Berenberg “This debate will be crucial for deciding whether to go below the neutral rate or not. In fact, it’s a mixture of both, which means that the ECB has to play its part. But rate cuts won’t be a panacea for the economy.”
While growth in the 20-nation bloc unexpectedly quickened in the third quarter, recent data signal a softening. Headwinds, too, are strengthening – from Donald Trump’s return and the trade tariffs that may follow, to the wars in Ukraine and the Middle East.
At home, manufacturing heavyweight Germany already faces a second straight year of contraction, plus snap elections in February. France, meanwhile – the euro area’s No 2 economy – is suffering its own political and budgetary turmoil.
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Against such a backdrop, trimming rates has obvious advantages: Shrinking household interest costs and making savings less attractive should stoke private consumption that’s just starting to show signs of life.
Cheaper credit could also nudge firms to invest – especially homebuilders – whose falling profit margins have been crimping their spending capabilities.
“Especially if there’s political vacuum it would be a signal of confidence if the only near-federal institution in the euro area demonstrates its ability and willingness to act,” said Gilles Moec, chief economist at Axa Group.
Italian central bank governor Fabio Panetta is among the loudest backers of quick-fire loosening and is not ruling out venturing into expansionary territory.
“In the current phase, we should focus more on the sluggishness of the real economy,” he said last month, warning that subdued domestic demand could cause inflation to fall short of the 2 per cent target.
But more hawkish policymakers such as Executive Board member Isabel Schnabel caution that rate cuts may not be effective if the issues they are aimed at tackling are also structural. Such weaknesses are myriad and also include poor productivity, diminishing competitiveness, unfavourable demographics and a lack of financial integration.
“If firms don’t invest for reasons other than monetary policy, lowering interest rates below neutral may not bring investment up,” Schnabel told Bloomberg in November. “You need structural policies to achieve that.”
In such a situation, the costs of moving could even outweigh the benefits by swallowing “valuable policy space” that may be needed to soothe future shocks, she said.
Complicating matters, Finland’s Olli Rehn has argued that the distinction between structural and cyclical is “never crystal clear”.
“Even though Europe’s longer-term growth and competitiveness challenges cannot be solved by monetary-policy tools, we know that investment is driven by many factors, not least by aggregate demand, which is obviously affected by financial conditions,” he said. After recent supply shocks, easing financial conditions should help avoid “scarring effects in investment that’s needed to increase longer-term productivity.”
Economists surveyed by Bloomberg reckon borrowing costs will settle at 2 per cent – a level seen as neither restricting nor stimulating growth. Markets envisage a more aggressive campaign, concluding about a quarter-point beneath that.
Whether the deposit rate – now at 3.25 per cent – is taken below neutral is perhaps the most controversial issue. Like Panetta, France’s Francois Villeroy de Galhau said in November that he “would not exclude it in the future, if growth were to remain subdued and inflation at risk of falling below target.”
But Bundesbank president Joachim Nagel has said he currently sees no “significant risk” of inflation undershooting 2 per cent that would warrant expansionary policy in the near future.
That’s the battle that’s set to play out over the coming months, though most economists are closer to those officials stressing a mix of cyclical and structural challenges and the limits of monetary policy – also worrying that the ECB may be overburdened again.
Rate cuts “won’t magically solve all the structural problems”, said Katharine Neiss, chief European economist at PGIM Fixed Income. “They need to come hand in hand with structural reforms, with complimentary fiscal policies. So, it really needs a unified, coherent policy package.” BLOOMBERG
