How much does the ECB's rate cut really matter?
The common reaction from the blogosphere and the financial press to the ECB’s rate cut last Thursday was that the ECB brought a powerful weapon to bear using interest rate policy. Bloggers such as Scott Sumner, Ashok Rao and Paul Krugman all the way through to Martin Feldstein in the FT saw it as an important step in the right direction towards a more expansionary monetary policy, albeit a belated one given the hawkishness of the ECB over the last couple of years. Professor Sumner, in particular, saw it as proof that the ECB could still steer aggregate demand through varying interest rates.
The basic reasoning is that the rate cut will lower short-term money market interest rates, and therefore shift the cost of funding downwards across the entire yield curve, giving a boost to spending in the Eurozone at a time when it is sorely needed. However this fails to account for how central banks try to manage short-term interest rates – because of current conditions in Eurozone money markets, the rate cut will likely have a surprisingly marginal impact. The key point is that though the ECB’s interest rate was not at its effective lower bound, short-term Euro rates have been, so that the rate cut will not feed through into the real economy. It was not the same as a quarter percentage point cut during normal, non-depressionary times, but much less potent. First though, we have to be clear on exactly how the ECB has been trying to shift interest rates.
How the ECB (tries to) control interest rates
The ECB manages short-term interest rates through a corridor system. It sets a deposit rate, the rate at which banks can lend to the ECB, and a refinancing rate, the cost of short-term borrowing from the ECB. Clearly interbank interest rates, and hence short-term rates across money markets as a whole, must lie between these two because of simple arbitrage. In effect then, the refinancing rate is a ceiling on short-term rates, and the deposit rate is a floor. Whether the actual short-term rate is closer to one or the other depends on the particular circumstances of banks and money markets. During the recent phase of the ongoing Eurozone depression, though, short-term rates have been stuck next to the deposit rate, at the zero lower bound, for the last couple of years. Why is this? The factors are long and complex. Surplus cash has been sloshing around the interbank system due to abundant liquidity provision by the ECB; banks are averse to counterparty risk from other financial institutions; they have been deleveraging rapidly and want to hoard liquidity; and they can make easy money through carry trades between negative rates in private collateral markets and the 0% yield from the ECB’s deposit rate facility. All of this means that banks are disproportionately likely to lend to the ECB, pushing down short-term interest rates towards the deposit rate. However on Thursday, the ECB cut the refinancing rate. Under current conditions this means very little for short-term interest rates simply because when they are bumping down against their floor (i.e. the deposit rate) it doesn’t matter how high the ceiling (i.e. the refinancing rate) is. The graph below shows this clearly:
Source: ECB, Euribor Rates
During the current phase of the crisis money market rates have tracked the deposit rate, but not the refinancing rate. In particular the rate cut in back in May this year had virtually no effect on money market rates. The point is clear – even if one of the ECB interest rates wasn’t at its lower bound, Eurozone short-term rates have been for quite some time, so that the refinancing rate cut should have little effect on them. We can contrast with the behaviour of interest rates during during happier economic times, when market rates tend to move much more closely with the refinancing rate because they are not close to their lower bound:
Source: Euribor Rates
In this way cutting the refinancing rate right now has little effect on the current level of market rates because of the peculiar current circumstances of money markets, and so will be far less potent than a quarter percentage point rate cut during normal periods. Clearly what matters more right now is the deposit rate. The ECB may start to charge banks for the privilege of holding on to their money, but the effects of such an unprecedented move are at best not well understood, and in any case cannot move far into negative interest rate territory before financial institutions will simply start to store money in physical paper form. Hence the Eurozone is well and truly at the interest rate lower bound where conventional monetary policy is exhausted, at least for the time being. Thus we get the whole host of macroeconomic problems associated with near-zero short-term interest rates combined with a recessionary environment, the phenomena which Paul Krugman so famously wrote about as a ‘liquidity trap’.
So what should the ECB have done?
Given that we can be sure that interest rate policy is constrained regardless of tinkering with the refinancing rate, we can draw on the deep understanding of monetary policy best practice during liquidity traps, established over the last 15 years. This culminated in an influential paper released by Michael Woodford, intellectual godfather of modern central banking, last summer. His key point is that in a liquidity trap, when interest rates are exhausted and an economy is facing a deflationary bust, central banks should stimulate demand through less conventional means. They can either boost the supply of credit to particularly sectors of the economy, as the ECB has previously done over the last few years with its LTRO programmes but is not currently expanding; or engage in forward guidance of the path of short-term interest rates, which the ECB has carried out in only the most cautious terms possible. By contrast, these are intiatives that the more progressive major central banks have endorsed whole-heartedly – and the economies of Japan, the US and the UK are far better off for it. Instead of following the broad technocratic consensus on the best way to stimulate demand when interest rate policy is exhausted, the ECB has responded with a far weaker tool in the form of its refinancing rate cut. Admittedly the cut did have some forward guidance effects, as markets perceived the ECB to be more dovish – stocks rose, the Euro fell and bonds rallied on the news. This is still, though, a weak way of achieving effective guidance because it is such an indirect method of signalling about future rates changes. As Frances Coppola points out, there are vastly better options on the table. Expansion of the LTRO programme would do much more to ease periphery borrowing costs, while there are better and more explicit ways of signalling future interest rate policy, such as interest rate guidance tied to explicit numerical thresholds, or quantitative easing.
Why is this important?
Despite its slight benefits, the reason why the rate
cut is so open to criticism is because it seems like a sidestep from the ECB.
It is a way of appearing to deliver
major monetary stimulus without doing
much at all. It allows the ECB to carry on doing close to the minimum
necessary to stimulate the Eurozone, even as it fails on its own terms – the
Eurozone is on course to enter a disinflationary bust, with core inflation
heading well below its (already highly conservative) mandate of an inflation rate
just below 2%.
Hence if the ECB does little more than a rate cut of questionable value, it will be a clear abdication of its responsibilities. Unless the rate cut is understood on these terms as a weak move, the ECB is absolved of some of its failure to prevent the current grinding stagnation, and for its inability to follow other central banks in adopting genuinely stimulative monetary policy in the face of a liquidity trap. Indeed in an ECB riven with internal politicking between core and periphery members, even the marginal move towards looser monetary policy represented by a rate cut is being cast as excessive by several Board members. A better understanding of the insignificance of the rate cut shows how disastrous this view is – and that if this is the maximum extent of expansionary Eurozone monetary policy, it is far too little, far too late.