Column: How Low Should Euro Rates Go?
Bond yields around the euro zone (both government and corporate) remain stubbornly high, suggesting traders have given up on bets for deep interest rate cuts. Equity prices continue to fall as profits dry. Inflation continues to slow as food and energy prices collapse. Confidence has done nothing but erode. Deflation beckons.
Yet the European Central Bank remains stuck to staff projections that the euro zone economy will shrink by just 0.5 percent this year while inflation slows to 1.4 percent and warns of a low-interest rate trap.
To be fair, fast and deep interest rate cuts aren't always the panacea for a slowing economy and a sclerotic banking sector. In fact, John Taylor, the Stanford University Economist and creator of the "Taylor Rule" of interest rate policy, suggests Ben Bernanke & Co's slash and burn rate strategy may have exacerbated, rather than blunted, the financial crisis by driving investment cash out of dollar and indirectly ballooning oil prices.
And credit has to be given to the ECB for its decisive moves at the early stages of the credit crisis to pump cash into the banking system and thereafter actively participate in weekly injections via the repo market (a much-ignored portion of ECB policy that should merit much more acclaim from critical commentators – your correspondent included!).
But with its main policy tool – as blunt as it might be – the ECB seems well behind the curve.
European companies rely heavily on banks for their capital: around 93 percent comes in the form of loans, the rest from the bond market. (The opposite is true in the United States). Bond financing is becoming prohibitively expensive in euros (single-A rated France Telecom will have to pay almost 2 percent more than market rates for a five-year bond deal) and banks are charging each other 0.6 percent for loans that last only a few months. Loan prices of any significant term are much, much higher.
While lower nominal rates probably won’t change risk premia for corporate borrowers, they will, of course, create lower borrowing costs. This not only helps the corporate sector increase investment activity, it also assists the banks' business model: more loans, more fees, better capital ratios.
Lower nominal rates will also ease financing conditions for euro zone governments preparing to boost their sagging economies through borrowed money in the government bond market. (Ireland, Greece, France and Portugal are all facing record-high borrowing costs based on market prices).
And we've not even addressed the clear impact a deep cut would have on business, investor and consumer confidence (not the arithmetic support for asset prices brought by a lower discount rate).
The case for a full point cut seems clear. And, sorry, no bonus points for those who anticipated the answer to my own question!