Why Europe Needs to Do More Than Cut Interest Rates

The European Central Bank needs to go beyond lowering interest rates – which has already been priced in by markets – to boost growth and authorities may be better off ramping up their asset-purchasing programs instead, economists tell CNBC.

European Central Bank
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European Central Bank

According to Shane Oliver, Head of Investment Strategy and Chief Economist at AMP Capital Investors, another rate reduction may not make a “huge difference” to Europe’s economy because low rates are not being passed through the system.

“They need to do something about the fact that the monetary transmission mechanism in Europe has broken down,” Oliver told CNBC Asia’s “Squawk Box”. “They’ve got record low interest rates but credit conditions in places like Spain, Greece, Italy and so on are incredibly tight. They should be playing a role in making sure that the bond yields in those countries come down.”

Bond yields in Spanish and Italian 10-year paper are at about 6.2 percent and 5.7 percent on Tuesday, compared to 1.6 percent on German government bonds, considered the region’s safest. To bring down the borrowing costs of Spain and Italy, for example, the ECB should follow the BOE’s move and buy those sovereign bonds, Oliver said.

Oliver’s comments came on the back of remarks by the head of the International Monetary FundChristine Lagarde to CNBC that easier monetary conditions may not be the best policy for Europe.

"The ECB has room available in terms of traditional monetary policy. We are not sure this is the best channel at the moment," Lagarde told CNBC’s Maria Bartiromo on Tuesday, when asked about the possibility of a rate cut. "Germany does not need a lowering of interest rates set by the ECB but Italy and Spain do, so you can't dissociate when you use that kind of monetary policy instrument.”

"On the other hand, the (ECB) asset purchase program is much more selective and can be used in a more judicious way," she added.

The European Central Bank (ECB) and the Bank of England (BOE) are both meeting on Thursday, and the former will likely cut by 25 basis points its record-low interest rates, currently at 1 percent, economists say. The BOE may introduce more stimulus after keeping the benchmark rate at an all-time low of 0.5 percent in June, they say.

David Woo, Head of Global Rates and Currencies Research at BOA Merrill Lynch in New York, agrees that central banks will probably have to be a lot more aggressive because interest-rate cuts have already been priced in by investors and may not have the desired effect of boosting asset prices.

He said that while consensus is for a rate reduction of 25 basis points by the ECB this week, they can probably cut rates by as much as 50 basis points, and do more by announcing a quantitative easing program by buying sovereign bonds.

“I think the market is definitely pricing in another round of QE .The markets have already to a great extent front-run policy makers so from that point of view, once these policies were to come through, I am not sure to what extent this is going to give risk assets much of an upside from here,” Woo told CNBC. “The point here is the market is expecting them to act aggressively so I’m not sure to what extent they will be able to exceed market expectations.”

- By CNBC's Jean Chua.