European Central Bank: Further Easing Needed

The European Central Bank announced that it will open to further easing in order to stimulate the economy. Euro weakens after central bank officials discussed possibility of asset purchases. At the same time, the rest of the world, for example the U.S. and China, are winding down their growth rate. According to Wall Street Journal, President Mario Draghi‘s revelation that the central bank had discussed negative interest rates and large-scale bond purchases — if needed to keep persistently low inflation from undermining growth — caught financial markets by surprise.

[Mr. Draghi said officials had discussed asset purchases, known as quantitative easing, as well as setting a negative rate on bank deposits parked at the ECB—moves that could help bolster the economic recovery and push up prices. The annual inflation rate in the euro zone is just 0.5%, far below the bank’s target of just under 2%.]

At the beginning of this semester, we learnt that the negative interest rates will encourage people to spend more which leads to an increase in aggregate demand; however, this may discourage you from saving your money – the more you save the more you would lose. Theoretically, people have less incentive to save and therefore banks have no reserves for lending loans.

A negative interest rate (though it is currently zero) would also force financial institutions to pay to park their excess funds at the ECB, leading them to lend more to the private sectors. However, in my opinion, quantitative easing is more complicated in the euro zone than in the U.S., where the Federal Reserve has deployed the policy and continues to do so. This is because on the one hand, like states in the US, countries in Eurozone have no exchange-rate tool, no separate monetary policies; however, on the other hand, unlike US states, labor is less mobile across countries and wages are less flexible due to social policies, and there is no mechanism for fiscal transfers among countries. The U.S. borrows more from the capital markets and therefore could filter quickly to its economy.

The good news is that euro zone has a low inflation rate. The long-term interest rates therefore remain quite fixed which provides a relatively stable environment for households and business to spend and invest. However, if the interest rates are too low, countries may face some risks, for example, Japan has struggled with deflation for two decades. In order to control the risk, both ECB and Fed aim to keep inflation rate at around 2%.




One thought on “European Central Bank: Further Easing Needed

  1. xcharles

    Interesting post. I was also following this topic and wrote a post on it when they were first considering negative interest rates. I like the fact that you incorporated how the situation will be more complicated for the ECB. A lot of people overlook the fact that each country in the Eurozone may be affected differently by certain policies.

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