Central Bank Inaction

No Powder Left to Shoot

draghi yellen david rubbs
How much cash have you got left? ECB President Mario Draghi and U.S. Fed Chair Janet Yellen.
  • Why it matters

    Why it matters

    China’s slowdown could provoke a global economic slowdown unless policymakers can find some way to stem the slide.

  • Facts

    Facts

    • China’s central bank cut its key lending rate by 0.25 percent on Tuesday to 4.6 percent in response to the country’s economic slump.
    • The European Central Bank and U.S. Federal Reserve have already brought interest rates to near zero following the 2008 crisis.
    • Both the ECB and Fed have launched quantitative easing programs that have involved buying more than $1 trillion in bonds.
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    Audio

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It was back at the high-point of the euro-zone’s debt crisis in 2012 that Mario Draghi uttered his famous declaration: The European Central Bank would do “whatever it takes” within its power to keep the euro currency afloat.

The problem: With China’s latest slowdown feeding its way into the European economy, the ECB president has hardly any power left.

The Frankfurt-based central bank has used up pretty much all of its available resources to jump-start Europe’s economy. In March, through gritted teeth, the ECB launched a bond-buying program totaling more than €1.1 trillion and running until September 2016. The “quantitative easing” program is designed to push inflation in the 19-nation currency bloc back up to nearly 2 percent in the coming years.

But the crisis in China has highlighted exactly what the top-table central bankers had feared: An external shock to the system could yet bring the ECB’s inflation goals, as well as the shaky European economic recovery of this past year, crashing to a halt. It’s a fear to which the ECB and other central banks would have no response left.

“I’m doubtful whether a further easing of an already very expansionary monetary policy will have much effect when an economic crisis in China penetrates the euro region.”

Jörg Krämer, Commerzbank chief economist

When growth in China shrinks, it has serious consequences for the rest of the world. The extremely weak oil price, the fall in value of the yuan and the stock market crash of the last few days are the first symptoms.

All of these factors add pressure to an already weaker-than-expected economic recovery and price trends in the euro zone of late.

The ECB can do little to counter this. “I’m doubtful whether a further easing of an already very expansionary monetary policy will have much effect when an economic crisis in China penetrates the euro region,” said Commerzbank’s chief economist Jörg Krämer.

Mr. Draghi isn’t the only central banker rattled by the turbulence in China. The decline on its stock exchanges has also derailed plans for an early interest-rate increase in the United States.

Many Federal Reserve watchers in the United States had been expecting the central bank to begin raising interest rates in September, a move that would mark the first increase since rates were brought to rock-bottom just after the 2008 crisis.

That September date now looks pretty unlikely. The worldwide turbulence is expected to cut not just the U.S. capital markets but could also impact economic growth, leaving everyone empty-handed.

For both the ECB and the Fed, the story’s the same: They’ve reached the end of their scope for action. The U.S. and European central banks have reduced interest rates to practically zero and have bought massive amounts of bonds.

Compare that to the central banks in emerging economies, who still have some room for action – China’s central bank showed this by cutting its own interest rates on Tuesday.

Even with the action taken by western central banks, inflation in the euro zone and the United States is already approaching zero. Prices in the euro zone in July rose just 0.2 percent compared to July 2014. In January the rate had fallen to minus 0.6 percent.

Economists ascribed the inflation gains between January and July to the depreciation of the euro as a result of the ECB’s bond purchase program. But that trend is now in reverse once again.

 

Market Changes 2-01

 

Because of the crisis, China has already devalued its yuan and could go further down this path in the coming weeks. That makes imports from China to Europe cheaper and makes exporting more difficult for companies on this end. For Germany, economically the most important European country, China is a vital sales market.

The euro has also gained in the last few weeks compared to the dollar. As the biggest importer of energy, China has an enormous influence worldwide on the price of oil and other raw materials. The oil price closed Monday at under the 40-dollar mark for the first time in six years – a year-on-year decrease of nearly 60 percent. This would definitely have a long-term positive effect on demand in Europe, though it will take time for this effect to work its way through the economy.

The global economic uncertainty has left many economists in doubt over whether inflation in the euro zone will rise 1.5 per cent until 2016, as the ECB has predicted. The recent appreciation in the currency and the drop in prices for raw materials are exerting pressure on prices, said Sylvain Broyer, an economist at the French investment bank Natixis.

There’s really only one thing the ECB can do: “Both trends give the ECB sufficient pretext for extending the program of quantitative easing past September 2016,” Mr. Broyer said.

Mr. Krämer also sees an extension as possible, even if he doesn’t envisage it having a major effect on Europe’s economy.

In the case of another major economic crisis, Mr. Krämer reckons that the ECB could also increase the pace of its bond purchasing, which is currently running at about €60 billion per month, and even lift its self-imposed restriction on buying no more than 25 percent of any outstanding government bonds.

A similar debate is underway in the United States over the postponement of what many experts thought would be a higher interest rate for September. The slump in the share market is now challenging the mettle even of hard-nosed hawks – a nickname for fans of a stricter monetary policy.

 

Market Changes 1-01

 

Some hawks are tacitly acknowledging that the timeline for the Fed’s first rate hike in nine years might have to be moved. Dennis Lockhart, head of Federal Reserve district of Atlanta, said he still believed in an interest rate increase from the Fed this year – but he notably left out the month of September.

Still, the Fed is also caught in a trap. Whoever sets interest rates at zero can’t reduce them further. A central bank’s classic instrument against a downturn isn’t available to the Fed.

As a substitute the Fed has inflated its balance sheet in previous years by buying bonds, much like the ECB is doing now. But since the Fed’s balance sheet has yet to be reduced, its chair Janet Yellen is unlikely to engage in yet another round of quantitative easing. Nobody knows how an ever-larger total on the balance sheet would affect financial stability.

There’s still the chance of a healthy development. If the stock market crash of the last few days turns out to be a corrective to overvaluation, then this won’t have any lasting damage to the U.S. or euro zone economies.

In this case, the Fed could increase the interest rate sooner rather than later and send a signal that central-bank policy is being further normalized.

Next week the investor community will again turn its eyes toward Frankfurt, where the board of the European Central Bank will be convening for its own rate-setting meeting.

But in the light of uncertain conditions in China, it’s difficult to see what Mr. Draghi and his fellow central bankers will come up with.

 

Jan Mallien covers monetary policy for Handelsblatt out of Frankfurt. Frank Wiebe is a New York correspondent for Handelsblatt,  focusing on finance. To contact the authors: mallien@handelsblatt.com and wiebe@handelsblatt.com

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