Investors will focus on the ECB this week. Here’s why.

This week, all eyes and ears will be trained on the European Central Bank (ECB) as it announces its monetary policy review on November 7.

True, over the past few months, Europe has rarely been out of the news for investors, mostly for troubling reasons. The latest bit of worrying news came as recently as last week, when data showed that inflation in the 17-currency eurozone slumped to 0.7% in October from 1.1% a month ago, much below the ECB’s stated goal of around 2% inflation in the medium term, considered ideal for economic growth.

Speaking about growth, there isn’t much of that happening either within the common currency area. GDP expanded at a feeble g 0.3% in the three months ending June from the previous quarter, a mild cause for celebration since it was the first quarter of growth after six straight quarters of contraction. Meanwhile, adding to the headache of European policymakers, the unemployment rate across the eurozone has climbed to a record 12.2%.

Hold on, there’s more. The euro has surged against the U.S. dollar this year, on the back of renewed uncertainty about the U.S. economy and stimulus ‘tapering’ plans by the Federal Reserve. The currency’s gains have been hefty – it recently breached the $1.38 threshold, which is its highest level in two years. But they are driven more by dollar weakness  and the euro becoming the top ‘anti-dollar’ bet than any underlying strength in the eurozone economy. Unfortunately, a strong currency is hitting European exporters, reinforcing the low growth-low domestic demand- and-falling-prices chain.

So what can the ECB do?  Typically, a central bank can cut interest rates to stimulate demand and prices. However, the benchmark rate, the overnight lending rate, is already near zero (0.5%), which is the lowest since the euro was introduced in 1999. The big question for investors is whether the ECB will cut the benchmark rate this week. The bigger question is, will a rate cut make any difference?

An Associated Press report suggests other options: lowering the central bank’s deposit rate below zero to discourage banks from parking funds with the central bank and making another offer of long-term cheap credit to commercial banks.

However, while these options put more money in the hands of banks, there’s nothing to guarantee the money will be used to lend actively, which, in turn, will boost economic activity, demand and prices. As has been done in the past, banks could simply choose to take the extra funds made available and stash them in ‘safe-haven’ government bonds.

It’s an interesting (not necessarily in a good way!) time for central bankers. The old tools of monetary policy are becoming increasingly useless under current monetary conditions (money is abundant but lending remains weak), forcing bankers to become more creative in the way they try to stimulate the economy.

We’ll have to wait until Thursday to see what new tool ECB President Mario Draghi uses this time around.

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One thought on “Investors will focus on the ECB this week. Here’s why.

  1. Pingback: Crystal ball gazing: Goldman Sachs’ predictions on interest rates | Wall of Money

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