July CPD Newsbrief — Investment principles and risk
The ECB’s big bazooka v2.0
Eurozone inflation has trended down from around 3.0 per cent in late 2011 to just 0.5 per cent today. That’s why so much attention was focused on the June meeting of the Governing Council of the European Central Bank (ECB).
Everyone was expecting something big. In the run-up to the meeting, Spanish, Italian and even Greek bond yields traded close to their pre-crisis levels. And in the event, the ECB did deliver something big:
- The main policy rate was moved from 0.25 per cent to 0.15 per cent
- The main deposit rate is reduced from 0 per cent to -0.10 per cent (commercial banks with excess reserves at the ECB will have to pay to keep those reserves there)
- The ECB will introduce a Targeted Long-Term Refinancing Operation (something similar to the Bank of England’s Funding for Lending Scheme)
- The ECB will ‘intensify preparatory work related to outright purchases’ of asset-backed securities (a form of QE)
The intended effect of these measures is straightforward: to maintain inflation at close to, but lower than, 2.0 per cent. The process by which these measures will take effect is less straightforward. The idea is to lower the money market rate, which in turn will lower the attractiveness of the euro on the foreign exchange market. Lowering the euro’s international purchasing power will have an impact on eurozone inflation (perhaps in the order of 0.5 per cent for every 10 per cent shift in the euro’s trade-weighted exchange rate).
In addition, the negative deposit rate and TLTRO programme is intended to stimulate bank lending to small businesses in an attempt to lift business investment and employment, which in turn ought to stimulate aggregate demand (including consumer spending) for goods and services, which in turn will have an impact on eurozone inflation.
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