03/05/2013 12:16 BST | Updated 03/07/2013 06:12 BST

ECB Fails to Restore Monetary Policy Transmission Mechanism


The European Central Bank (ECB) announced on 2 May its decision to cut the interest rate on its main refinancing operations by 25 basis points to 0.50%, and the rate on its marginal lending facility by 50 basis points to 1%. These moves could have a positive impact on the economy under normal circumstances, but their likely effectiveness given the depth of the euro zone's current problems is doubtful: with the transmission of monetary policy hampered in some regions, credit will remain tight where it is most needed.

The ECB's decisions follow a stream of weak economic data. We estimate that most economies in the euro zone suffered another economic contraction in the first quarter of 2013, and unemployment has reached new records. Inflation has also edged downwards in recent months, with average euro zone inflation falling to 1.2% in April 2013, its lowest level in three years and well below the official target of "close to but below 2%". Although base effects played a part, and inflation could rebound a little in the coming months, we expect inflation to remain well below target. Weak economic activity across the euro zone will further constrain core inflation, while energy-related base effects will add downward pressure on the headline rate of inflation in the coming months. This was tacitly acknowledged by the ECB's president, Mario Draghi, who referred to low underlying price pressure over the medium term.

Policy transmission problems

Against this backdrop, the ECB had little choice but to cut its main refinancing rate. However, we expect the ECB's move to have little effect on the euro zone's economy, mainly because the so-called transmission mechanism (in other words the way in which ECB rates are translated into funding costs for companies and households) has broken down in some peripheral countries.

Despite admitting the fragmentation of European financial markets and the need for cheaper funding in weaker economies, Mr Draghi did not announce concrete moves to address the problem, instead urging national governments to speed up the creation of a banking union. A functioning banking union, he argued, would go a long way towards reducing the fragmentation of credit markets. In the meantime, the ECB's policy would remain "very accommodative", as illustrated by the bank's extension of its commitment to supplying cheap short-term liquidity. With low interest rates and still substantial excess liquidity in the euro system, Mr Draghi insisted that there was "no excuse" for banks not to lend to businesses.

Nevertheless, because he ruled out more unconventional measures aimed specifically at lowering interest rates in the credit-starved peripheral euro zone states--such as direct intervention in some markets or a relaxation of collateral requirements to include loans to small and medium-sized enterprises--the rate cut will have little effect on lending rates in peripheral economies.

The impact of the rate cut will therefore be mainly felt in core countries such as France and Belgium, which already saw their bond yields fall during the press conference, and most importantly in Germany. However, because the German economy is performing much better than most of its European peers, some critics have warned of the dangers of lower rates in the present situation. This was reflected in Mr Draghi's announcement that the decision to cut the main rate was "not unanimous", highlighting the diverging views among the members of the ECB's governing council. There is therefore a strong risk that the ECB's room for manoeuvre will be limited in the coming months.

The ECB also cut the marginal lending facility (MLF) rate by half a percentage point, which could have some positive consequences in countries where the financial sector is ailing. Most importantly, because interest rates on Emergency Liquidity Assistance (provisional liquidity made available by national central banks to troubled banks under certain circumstances) are usually pegged to the MLF, this rate cut will provide some breathing space to the banks concerned.

Overall, however, given the combination of the ECB's unwillingness to address financial market fragmentation and the current austerity drive in most euro zone countries, we continue to expect a continuation of the economic crisis in the remainder of the year.