The European Central Bank in Frankfurt

ECB Announces Welcomed Stimulus Plan, However the Outlook Remains Uncertain

The European Central Bank (ECB) announced a €1 trillion stimulus plan this week designed to combat deflationary pressures in the Eurozone.   Stagflation and deflation have emerged as the latest threat to economic recovery in Europe and around the world.  In December, consumer prices actually fell by 0.2% across the Eurozone.

U.S. and stock markets around the globe reacted positively on Thursday to the news.  U.S. stocks have rallied all week based on the expected stimulus along with better than expected earning announcements.   Markets expected a move from the ECB, but the size and scope was a positive surprise.  The door was also left open for additional actions that could spur investment to ignite growth in a very stagnant Europe.

Details of the €1 trillion stimulus

The ECB will purchase €1 trillion ($1.57 billion) worth of debt from the public and private sector through September 2016 as part of its quantitative easing policy (QE).  It will purchase €60 billion in assets per month from member governments and private sector companies in them.  It will start to make purchases in March 2015.  The door was left open to extend the stimulus plan beyond September 2016 if inflation does not hit levels close to the annual stated target of 2%.  The ECB expects its balance sheet to reach the highest levels since 2012.

Mario Draghi, ECB President, also stated that the Eurozone central banks will share the risks from debt purchased from EU institutions, but the central banks will not bear risks from losses associated with the purchase of government bonds.  As part of the stimulus package, interest rates on four year loans were also cut by 10 basis points.  The other benchmark rates remained at record lows with the overnight rate actually negative.  Member institutions would have to pay to store money at the ECB overnight.

The policies are all designed to push money into the economy through increased lending and investment.  The effect here is twofold.  First, by increasing the money supply in the market, it should help maintain current price levels and drive them closer to the 2% targeted inflation rate.  The forces of supply and demand act here.  In addition, low interest rates and increases in the money supply also are meant to encourage lending and investment.  Increased investment from governments, businesses and consumers should increase the number of jobs in the market and along with spending activity.  This acts as a stimulus to the flattish growth situations in most of Europe’s economies.

What to do with Greece?

There was no guidance in the announcement on the ECB’s plans for Greece, and how it would deal with a political shift there.  There is increasing pressure in Greece for it to abandon the required austerity measures imposed by the ECB.  An upcoming election and political pressure could result in Greece abandoning certain polices it had to adopt.  I would also likely want to resume deficit spending.  In order to do this, Greece needs either the ECB to buy its junk rated debt, or it would have to pull out of the Eurozone and find buyers for its debt elsewhere.   If measures are relaxed by the ECB for Greece, it could impact decisions by governments in the rest of Southern Europe and also in France.

Similar approached used in the ROW post-economic crisis

The move is welcomed by markets since it adopts an approach used by the U.S., Japan, and the U.K. following the financial crisis.  So far, the ECB has attempted to use low or even negative interest rates to encourage lending and stimulate growth.  This has not worked and most of Europe’s economies have struggled to find consistent growth.  Many on the Street hope this change in approach is also a sign the ECB is focused on more than just maintaining its targeted inflation rate, and it will continue to adopt pro-growth policies.

On the other hand, this may not provide enough boost to stagnant economies like France and Spain and the more troubled ones like Greece and Portugal.  These countries may need more targeted measures, but their monetary and fiscal policy options are limited by ECB rules.

 

Currency markets in flux

All this action has impacted exchanges rates.  The Euro has declined versus the dollar behind European troubles in recent months and even more so since the market started toEuro expect a QE policy change.  Along these lines, the cheaper Euro will help make Europe’s exports cheaper abroad.   It could also spark other governments outside the Eurozone to take action. The Swiss changed their fixed exchange rate last week which sent turmoil through currency markets.  Japan is Germany’s biggest competitor in the export of automobiles, and its central bank could take action to improve the attractiveness of their exports.  In addition, the USD has risen compared to currencies around the world and at some point that will impact U.S. economic growth.  If the dollar’s value continues to increase, the Fed will eventually have to start looking into policy changes.

Conclusion

The ECB stimulus action is welcomed by investors around the world.  It could act as a catalyst for growth in the region.  That said, a recovery is still anything but certain in Europe, and the global economy remains fragile.  Outside the U.S., the situations remain risky.  If international markets do not improve, how long can the U.S. remain an island of stability?

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