The European Central Bank has lost the plot on inflation
The deposit rate, at which banks park their reserves at the central bank, is down from -0.3 to -0.4 per cent. Mr Draghi hinted that we should not expect further cuts in that rate. And that line was the really big news of the day. He did not so much cut the rates as end the rate cuts.
This is why the euro first fell — then rose when investors realised this rate cut was not what it seemed.
There is nothing fundamentally wrong with any of the decisions except that the ECB missed a trick. It could have widened the spread between short-term and long-term interest rates — or, in financial parlance, it could have steepened the yield curve. One method would have been to make a bigger cut in the deposit rate and a smaller increase in the size of asset purchases. Since asset purchases reduce long-term rates, a small increase in purchases would have reduced them by less.
There are big problems with a flat yield curve. It is a nightmare for the banks because their business consists of turning short-term savings into long-term loans. When long rates are similar to short rates, banks find it hard to make money. They have to find other ways to generate income. Think also about the deeper meaning of a flat yield curve with all interest rates near zero per cent.
Assume you trust Mr Draghi’s commitment to the inflation target. Would you, as a private investor, buy a 10-year corporate bond that yields 0.5 per cent? If inflation really were to reach 2 per cent within two or three years, you would surely make a loss. The only reason you would want to make a long-term investment at these rates is that you do not believe in the target.
Long-term rates are low because people believe the ECB has lost the plot on inflation. I, too, believe this.
The QE programme ended the credit crunch in Italy last year. But the marginal benefits of these policies have been diminishing. Piling on a few more purchases will not make a huge difference.
What about the targeted longer-term refinancing operations? The nominal rate charge to banks using this will be zero but they will receive a discount, the size of which depends on how much they lend. For the first time, it will be possible for them to secure ECB money at negative rates — at up to -0.4 per cent. So when they borrow €1,000 today, they repay only €996 in a year’s time.
Maybe the pessimism is overdone, the recovery is stronger than many think and the eurozone will perform “better than expected”. But, since this has not happened in a long time, it would be wise not to base policy on that hope.