ECBs Decision and Alternative Policies - Essay Example

ECB’s decision and alternative policies s Submitted by s: Introduction The European Central Bank is the central bank for the Euro, which is the currency that is used in Europe with its main task being to maintain the purchasing power of the Euro and in the process the stability of this currency in the region (Singleton, 2011, p. 268). The area that is covered by the Euro includes nineteen countries that have been using the Euro since 1999 (Beblavý, Cobham and Ódor, 2011, p. 25). The ECB has reduced interest rates to record low points as it tries to stimulate inflation and it further made the announcement of a new credit scheme that will inspire lending while pumping money into Eurozone banking. Mario Draghi who is the president of the European Central Bank made the announcement that the bank’s governing council had plans of launching an initiative of asset backed securities which will but financial assets from banks and other investing institutions. This scheme will assist banks to sell bundles of assets including loans to companies and mortgages to the ECB, and even though the full details were not disclosed immediately, there is likelihood that the bank will commit a lot of Euros to this. The main idea is that the banks will develop a will to make loans to the real economy if they are able to package the debt into newer securities and consequently sell them to the ECB. This essay seeks to explain the decision that was taken by ECB concerning interest rates while at the same time analyzing the alternative policies that the bank could have considered. ECB’s decision and alternative policies The ECB has two main objectives with the key objective of the two being to use monetary policy to maintain stability of prices (Kaltenthaler, 2006, p. 127). The bank has a set goal for an inflation rate that is acceptable, which is below zero every year and this is among the ways that the ECB is different when compared to the US Federal Reserve that has more flexibility in the establishment of permissible inflation rates. Another dissimilarity between the two banks is the fact that the ECB emphasizes more on transparency and making the investors aware of its intentions. The inflation target being the main goal for the bank has created a key source of criticism for the bank and numerous people believe that this main objective is too narrow and should encompass other equally important goals like the achievement of full employment. Further, the lesser objective if the ECB involves supporting the general economic policies that affect the Eurozone. This means that the bank attempts to make sure that the stated goals of the European community are achieved including attaining a high level of employment while making sure sustainable and non-inflationary growth is maintained. Some of the other duties of ECB include the conduction of foreign exchange operations, operation of payment structures, issuance of bank notes as well as supervision of credit institutions. Decisions concerning interest rates, which are announced by ECB typically a considerable effect on exchange rates of the Euro: for instance, in the event that the ECB decides to increase the interest rate, then returns associated with Euro assets will seem to be more favorable to the investors while the currency will experience an appreciation in value. Consequently, a situation where imports for citizens in the Euro area and exports are more costly for the rest of the world will arise. Conversely, if the ECB decides to decrease the interest rate, the Euro assets will not appeal to investors and the value of the euro will depreciate making imports become more costly for people in the Eurozone while the exports become appealing for other countries outside this zone. In an attempt to keep low inflation from causing derailment to the Eurozone economy that is already weak, the ECB surprised financial markets when it reduced the interest rates and introduced new stimulus plans regardless of some opposition from Germany’s central bank that wields a lot of power (Touffut, 2008, p. 40). This mover pummeled bolstered the economy while at the same time boosting European stock and bond prices. They have also exhibited the progressively divergent paths the exist between the central banks of the US and the UK that are considering stiffer policies, and the ECB as well as other central banks in the European continent that are increasing their stimulus efforts. The expansions seen in the US and the UK are more vigorous and enriching than those associated with the Eurozone and their inflation rates are near the 2% pace which the main banks see as optimal for their economies. This decision has left numerous economist surprised at the super-charged package aimed at easing various aspects. Immediately after the ECB reduced these rates, the Euro fell by 1.6 percent against the dollar, which signified the lowest point in fourteen months (Detrixhe, 2014). The president of ECB gave a comprehensive list of worrying developments that forced the central bank to take action, which ranged from plateaued growth to weakening inflation. The decrease in the interest rates came three months after a historic stimulus package and only about two weeks after the president of the bank had indicated that he was ready to take more measures. Other additional measures that he could reveal later may comprise of a purchase program for securities based on assets or a larger program founded on quantitative easing of the risks that divide policy makers. The decrease in rates was announced after the GDP in the Eurozone plateaued unexpectedly with the three biggest economies failing to record any growth. Germany’s economy, which is the leading in this area, shrivelled by 0.2 percent signalling its only weakening from the beginning of 2013 (Sinn, 2007, p. 51). Inflation in the Eurozone was 0.3 in mid-2014, which denoted the weakest point since 2009 and a fraction of the two percent objective of the bank. Earlier, the central bank had made a prediction of an average of 0.7 percent for 2014, which was a level that was crossed only once in the entire year even though a prediction of one percent growth did not happen because of the stagnation that was experienced in the last quarter. In June 2014, the president of the central bank had stated that for all the practical purposes, it had reached its lowest bounds and this had led to the slashing of benchmark rates and reduction of deposit rates to negative while stating that any more changes would be predominantly technical adjustments. However, the Bank of England did not adjust its key interest rates, which are at a record low of 0.5 percent, and its Sweden counterpart maintained its rate at 0.25 percent. If the ECB commits itself to the purchase of ABS bonds, then this would be a step up from the previous months when the president of the bank had stated that the final decision was reliant on the actions of numerous other actors. Numerous economists have wondered if the ECB is doing enough considering the prevailing economic position. The bank has employed most of the conventional measures and what remains is probably quantitative easing. The bank mat probably purchase bonds issued by government agencies in the region along with corporate bonds and bank debts, as it may be pose more problems to purchase bonds from individual countries. However, in order to employ quantitative easing, the president will have to create a consensus among the members of the governing council in the same way he did in the push for the policies that reduced the benchmark rates. During the summer of 2012 when the crisis was flaring afresh, the president was able to build internal support for a promise that backstopped the nations’ government financially while doing whatever it took to preserve the unity of the region. The support of Germany, which is the biggest country in the Eurozone, is considered as being significantly vital, as previously, opposition from the country’s influential central bank has weakened backing for the ECB. Regardless of the challenges being faced by the ECB, the clearest roadmap of what an asset buying initiative for the bank would be like involves the intensification of preparatory work that is associated with outright purchases and this would involve buying asset-backed securities in the private sector. The impact of this would be limited since the number of securities that will meet the requirements will be comparatively small; however, the plan will bring the ECB nearer to a wider asset buying initiative. The ECB will also start offering four-year loans to banks based on the benchmark interest rates on conditions that are supposed to ensure that the lenders utilize the money on issuing of loans to businesses (Carrel, 2014). Banks will be obligated to demonstrate their net lending for organizations has grown as a consequence of the cash they get from the central bank and if they cannot do this, they will be forced to make early repayments. Alternative policy that could be used to stimulate the Eurozone economy It has emerged as a new conventional wisdom that when all other approaches fail to create growth in economies, new money should be created and government bonds purchased. This formula is known as quantitative easing and numerous economists consider it as the factor that assisted the US as well as other countries that have employed it, not to tumble into catastrophic depressions. It may prove to be challenging for Europe to adopt this approach partially because of the EU regulations as well as the concerns associated with encouraging asset bubbles. However, since Europe has exhausted almost all the options it has had before; it has to go ahead with some asset purchases and other approaches that resemble quantitative easing in order to inject more cash into the economy. Since the fragile recovery of Europe lags behind the rest of the globe and inflation has been running at a fraction of the goals set by the ECB, the president has raised the prospects linked to large-scale purchase of assets. ECB began buying covered bonds in 2014, which are a form of debt with security in loans like mortgages while starting to buy securities supported by assets later same year. Regardless of this, it has not embarked on complete QE that targets government bonds in the midst of backing among the members constituting the governing council. In spite of the controversy surrounding the setting, the purchase of assets is not a new aspect to ECB as it has purchased on previous sovereign debt from nations such as Greece and Spain between 2010 and 2012 together with covered bonds between 2009 and 2012. In June 2014, the ECB was the first main central banks to lower its interest rates past zero while designing a lending program that tied the amount the bank was able to borrow to the amount of credit it gives to organizations and individuals. The bank also continues to provide cheap loans to any bank in need of it during regular operation, which is a type of on-demand form of quantitative easing. The contemporary EU is based on agreements that prohibit the ECB from financing governments and Germany’s central bank has been especially outspoken against the expansion of the supply of money. According to Germany’s central bank, this move risks inflation and at the same time decreases the incentives for administrations to cut down on overspending in order to make their economies more competitive. On Germany’s part, it is about values despite the fact that deflation is currently considered as a greater danger compared to inflation. Previously, the ECB had the capacity to add up to one trillion Euros to its balance sheet, as the magnitude of stimulus measures was comparatively small. Since deflation has become a central concern in the Eurozone, there are increased chances for quantitative easing like the one employed in the US regardless of the challenges that will be experienced politically and in practice. Organizations obtain most of their funds from bank loans instead of the sale of bonds, which is a commonplace occurrence in the United States and this makes the financial markets in Europe smaller and with little liquidity. The costs of government funding also vary broadly throughout the region. Therefore, in the event that the ECB bought sovereign bonds that were proportionate to the size of its member nations, more than fifty percent would be sourced from countries such as France and Germany where the yields are low. If peripheral countries are targeted, efforts to make them cut on spending will be undermined and the bond yields in nations such as Italy and Spain are near their lowest points in history. There are also debates concerning the effectiveness of quantitative easing and concerns that it encourages asset bubbles since money goes into stocks and other assets rather than being of benefit to organizations and individuals. Conclusion The ECB’s president gave a promise at the peak of the debt disaster in 2012 that his institution would take all the necessary actions to save the Eurozone currency from collapsing. This promise led to an experimental Outright Monetary Transactions program, which was a bond-purchasing plan by the government that required nations to agree to particular conditions. The program is under review by the highest court in the European Union after a German court stated it would violate the law if it heard the issue. After the central bank lowered the benchmark interest rates, it is still not clear if the banks in the Eurozone will react to these actions as numerous banks are already dealing with issues of problem loans. If the cuts in interest rates filter the market, they may be helpful but will not be enough to deal with the issues at hand. Many businesses have continued to struggle for the last few years partially as a result of the decreased or closed credit lines by banks after the straining recession. However, considering the high amount of nonperforming loans, the measures that were taken by the ECB may not be able to provide the liquidity that is required to help in jumpstarting business activities. It can then be concluded that the main reasons why banks are not lending out money is that they are aware that they will lose the money. Line diagrams Bibliography Beblavý, M., Cobham, D. and Ódor, L. 2011, The Euro area and the financial crisis, Cambridge University Press, Cambridge. Carrel, P. 2014, Crunch loan offer may hold key to next ECB policy move. [online] Reuters. Available at: http://www.reuters.com/article/2014/12/11/us-ecb-policy-loans- idUSKBN0JP00H20141211 [Accessed 7 Jan. 2015]. Detrixhe, J. 2014, Euro Drops to 14-Month Low on ECB; Dollar Strengthens. [online] Bloomberg. Available at: http://www.bloomberg.com/news/2014-09-04/euro- declines-to-14-month-low-after-ecb-unexpectedly-cuts-rates.html [Accessed 7 Jan. 2015]. Kaltenthaler, K. 2006, Policymaking in the European Central Bank, Rowman & Littlefield, Lanham, Md. Langran, R. and Schnitzer, M. 2007, Government, business, and the American economy, Rowman & Littlefield Publishers, Lanham. Singleton, J. 2011, Central banking in the twentieth century, Cambridge University Press, Cambridge, UK. Sinn, H. 2007, Can Germany be saved?, MIT Press, Cambridge, Mass. Touffut, J. 2008, Central banks as economic institutions, Edward Elgar, Cheltenham, UK. Read More