The ECB Fiddles While Rome Burns

Currency in Crisis

The ECB just doesn’t get it. The Federal Reserve has driven the Fed funds target to 0-25 bp. Short-term US T-bill yields have on occasion dipped below zero. As this is written, the 3-month T-bill yield is quoted at -5 bp. And still there is demand.

What the ECB doesn’t get is that sometimes the demand for money is inelastic to its price. Simply put, it means that the low cost of money, i.e. interest rates. does not necessarily increase demand.

Seemingly still reluctant to appreciate the magnitude of the economic and financial tsunami, the ECB fiddles as Rome burns. On Thursday, the ECB announced that it would cut the interest rate it pays on money deposited with it and raise the rate that it charges to borrow money from it.

Previously it paid 50 bp less than its refi target rate, now at 2.50% and charged 50 bp more for its emergency lending rate. Now the spread will be 100 bp. But there is no sense of urgency. Today’s measures will not be implemented until January 21, more than a month from now.

Ostensibly the move is to discourage banks from leaving excess deposits with the ECB. These deposits are similar to the excess reserves that banks are leaving with the Federal Reserve. The deposits at the ECB are running more than 4 times the long-term average, according to Bloomberg data. The hope is that this interest rate adjustment will encourage banks to take the money from the ECB deposits and loan to households and businesses. Fat chance.

The reason European banks, like US banks are not lending has a supply and demand component. The supply is being constrained by banks rebuilding their balance sheets. The demand is being constrained by risk averse households, rising unemployment, a dramatic slowing of the economy, rising rates of unused industrial capacity, leaving businesses reluctant to borrow.

The animal spirits have been brought low and it clearly requires more than lower rates. Isn’t that a lesson from Japan for nearly the past two decades and what the US is experiencing now?

The ECB did confirm it will continue providing unlimited liquidity at its fixed rate through at least Q1; Helpful for sure, but still far from sufficient. Several ECB officials including President Trichet, have played down the likelihood of a rate cut next month. However, in nearly the same breathe officials remind investors that the ECB does not pre-commit to a rate move. Nevertheless, recalling the June ECB meeting earlier this year, when Trichet signaled a rate hike in July, some market participants are anticipating a cut next month.

The ECB needs to cut interest rates. Clearly price pressures are falling abruptly and the regional economy is slowing dramatically. Even those who believe that Trichet is in fact pre-committing now, expect the ECB to cut rates in February. Given the lag times involved with monetary policy, there arguably is no material difference between a Jan and Feb cut.

The difference is significant on two scores. The first is the type of leadership it can provide. Leadership by example can be most powerful. It says to the politicians, this situation is urgent. Then there is Trichet, with the ever firm grasp on the obvious, noting that rates can be cut only so much. While the obvious barrier is zero, some council members have indicated discomfort with cutting rates below 2%. Even though the crisis is making policy makers and investors make decisions, the ECB is not at that self-imposed boundary. By getting there quicker, the ECB puts the burden a bit more on the fiscal policy.

The second way that a January rate cut is preferable to a Feb rate cut lies in the important area of public relations. The central bank finds no difficulty in warning against wage increases, but said not a word about record corporate profits. Why should it take a stand, and sometimes threaten to hold monetary policy hostage to how labor and capital divide the gains from productivity? In this regard, the ECB takes a side in a private sector concern against working people.

Moreover, the ECB like other central banks, has a great amount of power and discretion, but is not really accountable to the citizens of the region. The ECB of course has opposed any effort by the European finance ministers or governments to influence its decisions. It took nearly half a century for the US Treasury and the Federal Reserve to work out a modus vivendi and division of labor in monetary matters.

Delaying the inevitable creates no advantages and needlessly shrugs off the pain the financial and economic crisis is causing. The ECB’s rate hike in July, only to be reversed within 12 weeks, and amid this horrific crisis, tarnished its image and not to cut rates at its earliest opportunity risks compounding that injury.

The ECB also announced something else that seems to pit expediency against its strategic objectives. The Maastricht Treaty that laid out Economic and Monetary Union seems to require that as EMU grew to 16 members, its decision-making structure would change. Slovakia is set to become the 16th member of EMU on January 1st, 2009. With little explanation, the ECB said that despite the rotating arrangement envisaged by Maastricht, all members would continue to vote.

For its part, the euro has screamed higher in recent sessions. Since testing the $1.25 area, the lower end of its consolidative range since late Oct, on Dec 4, the euro rallied more that 17% against the US dollar through the high set on Dec 19th. The rally in the euro, no more than the sharp rise in the yen does not reflect a constructive economic outlook.

With carry trade strategies challenged by record levels of currency volatility, momentum traders have a freer hand. The euro lost its downside momentum in late Oct and momentum traders have in recent weeks cut back short euro exposure. The loss of momentum also encouraged some commercial and financial participants to lift short euro hedges. With the upside break in the euro at the end of last week, some momentum traders have jumped aboard, forcing other euro shorts out.

But this seems largely a technical move, which, while it may have some more room to run, is likely to provide medium and long-term investors with a new opportunity to sell the euro and buy the dollar. We will be looking for some technical indicator to fine tune our timing, but we currently anticipate that what is largely an overdue technical correction in the euro will run out of steam in the first half of January.