ECB reacts to below target inflation with a rate cut
In layman’s terms the ECB is trying to inflate Germany
On November 7th 2013 the ECB surprised many economists with a rate cut of 25bps to its marginal lending fascility.
What does this all mean though?
It is well known (or rather well established) that the Euro area is NOT an optimum currency area,in a nutshell 17 (now 18) very different economies share one currency (compare with the USA which is a currency union of 50 federated states).
As a result this rate cut won’t trickle down equally across the euro area and there is ample evidence to support this theory.
Examine the EONIA and ECB’s marginal lending facility rates historical data
If the rate cuts (marginal lending facility) were equally felt across the euro area then it stands to reason that we should observe similar if not identical patterns in lending rates offered by banks.
In this example we’re comparing lending rates for 1 year business loans up to 1mn euro for Germany Greece and Spain.
Notice that only Germany’s pattern resembles EONIA and ECB lending rate patterns. Greece and Spain followed similar course until 2010 and then all of a sudden regardless of ECB’s rate cuts there was no effect on interest rates in these countries.
The reason is ofcourse the euro crisis (which won’t be analysed here). Everyone who’s been reading the news will notice that there is a shortage of affordable credit in the periphery of the Euro area that forces small and medium enterprises (SME’s) to close shop. No matter how many rate cuts the ECB does those won’t trickle down to the real economy and even ECB’s own board members agree!
The Cypriot Central banker issued a statement commenting on ECB’s decision to cut rates
The transmission of monetary policy in Cyprus, however, depends crucially on the health of the financial system.
Substitute Cyprus for whatever country in the periphery and the above statement still holds.
In an ideal world a rate cut by the central bank would make credit affordable and businesses would start expanding regardless of where the bank is located. Evidently the eurozone is not an ideal world.
So the above beg the question:
Why did the ECB proceed with a rates cut?
On October 31st the European Statistical Service Eurostat announced its inflation flash estimate that came in well below ECB’s target of 2%
Looking at Eurostat’s inflation data for Sept.2013 on a month to month basis (individual country data for October is still unavailable but it will be a similar picture).
Notice that the euroarea’s 2 biggest economies are in disinflation territory. Note that Germany’s inflation rate has essentially flat lined. In fact German inflation has remained unchanged since last July!
And we all know that Central Banks like their inflation!
So let’s add the two together. It has been established that German bank interest rates strongly correlate with those of the ECB. Therefore a rate cut by the ECB will have an impact in Germany. As credit gets cheaper (hopefully) consumption by the private sector will pick up causing inflation.
In essence the ECB is trying to inflate Germany.