The European Central Bank Eases. Will it Help?

In an effort to stimulate a lethargic economy and stave off impending deflation, on Thursday, June
5th, the European Central Bank(ECB) cut its main rate from 0.25% to 0.15%, cut its marginal lending facility from 0.75% to 0.40%, offered its longer-term refinancing operations (LTRO) and imposed a negative interest rate on bank deposits(from 0.0% to negative 0.10% - the first ever by a major global central bank). In an odd and unexpected twist, the Euro actually rose after the move. The rising Euro, if it were to continue, would act to defeat the efforts by the ECB. Despite the moves made by the ECB, and the resulting impacts on currencies and markets, will they have the desired benefit of stimulating the European economy?

The Deflation Threat

The ECB has targeted 2.0% as its desired inflation rate. Last month inflation was running at around 0.5% in the Eurozone. One of the biggest fears of advanced economies is the specter of deflation, which we have covered extensively on this blog because of its debilitating nature to an economy. In a nutshell, deflation dampens economic activity for various reasons, not the least of which, is causing the consumer to put off purchases in the face of falling prices. If the ECB is to be successful in stimulating economic growth, it must first combat deflation.

Austerity to Blame?

To combat the global recession, the European Union adopted austerity measures in hopes that it would allow them to reduce the amount of debt overhanging its members. While certain levels of austerity are helpful when recovering from economic recession, an overwhelming amount can harm growth and limit the speed of a recovery. The most efficient response to the economic weakness was not to curtail borrowing as much as it was to provide the environment for healthy borrowing through lower rates and solid credit policies. Cutting back credit would only serve to limit growth potential and spur further deflation.

Draghi to the Rescue? The New Bernanke?

With austerity measures fully in the rearview mirror, the ECB's head, Mario Draghi, has unleashed the aforementioned measures in one fell swoop, but came just short of implementing US style asset purchases. The assumption here is that they're coming, and Mr. Draghi is simply biding his time. If the recently implemented measures fail to accomplish the desired results, a healthy round of asset purchases will inject liquidity in to the economy creating the necessary 'wealth effect' and in effect buying yet more time for things to improve. With the US as a proxy, the Eurozone can use this blueprint and better anticipate the results. Rising equity markets is one expected outcome. Will this be enough to stimulate economic growth and lead to a hiring boom, something the US claims to be experiencing? It's difficult to tell, as Americans and Europeans are alike, and they're not. The employment rate in Europe is significantly higher than the US, indicating a more severe structural problem, maybe not easily solved through liquidity.

Effects on US Markets

One of the conundrums facing the US market was falling interest rates, leading some economists and analysts to worry that a recession was in the offing. However, more likely, it was a result of the impending Eurozone stimulative measures. In addition to falling US rates, equity markets have responded favorably to the moves, with US equity indices at record and historical levels. Most global equity indices are following suit with European markets are equally reaching record levels. Are these record equity levels a boon that should be enjoyed or are they indicative of the effects of rampant global liquidity injection and should investors be wary? Only time will tell, but an old cliche can provide some perspective: "There are no free lunches..." In other words, if rising equity markets seem too good to be true, they probably are.