The ECB’s latest rate cut and 36 month liquidity operations can ease interbank liquidity problems, but it acts more as a painkiller for a bullet wound and much deeper surgery is needed in the form of Euro Zone restructuring. Since the first shot hit the Euro Zone two years ago, Euro-Zone politicians have only tentatively prodded the wound with their scalpels. Politicians must dig deeper and complete the operation to ensure that the patient can be taken off the critical list.
1) Euro-Zone CPI
Despite the austerity packages unleashed across the Euro Zone, CPI in all except one EZ country is still above the ECB’s target inflation “of below, but close to, 2% over the medium term,” with the EZ average at 3%. Despite this, the ECB have cut rates again from 1.25% to 1% as the sovereign debt crisis rages on and GDP forecasts have been cut. The implication is that demand will fall leading to downward pressure on CPI.
Figure 1: Comparison of CPI across Euro-Zone Countries. Source: Eurostat.
2) Euro-Zone GDP
GDP across the Euro-Zone countries has already begun to dip, as can be seen below. The outlook is even worse given the freezing up of liquidity in the banking system which means less cash is being distributed to the wider economy. High levels of uncertainty in the Euro Zone means consumer spending is more conservative while investors would rather delay investment decisions until the outlook of the Euro Zone is clearer.
Figure 2: Comparison of year-on-year GDP growth rates across Euro-Zone Countries. Source: Eurostat.
3) Euro-Zone Rates
Figure 3: Comparison between Euro funding rates. Source: ECB.
Interbank lending rates, measured by 3-month Euribor, have increased again in the last six months as the Euro-Zone crisis has escalated. Banks with cash are hoarding it and are less willing to lend out to banks who may have large exposures to risky sovereign debt. The stresses in the interbank market can clearly be seen by the 3-month Euribor/Eonia swap spread which is rising as tensions build.
A combination of long-term liquidity provision combined with credible restructuring of the Euro Zone including commitments to fiscal union and importantly, a structure allowing for the transfer of wealth across Euro-Zone countries to aid countries that cannot ease monetarily due to the ECB’s one-size-fits-all repo rate.
4) Demand at ECB Long Term Refinancing Operations and Main Refinancing Operations.
Figure 4: European bank demand for additional funding from ECB. Source: ECB.
Another sign of uncertainty and stress rising in the banking sector. Demand for liquidity from both the LTROs and MROs has again risen in recent months.
5) ECB Deposit Facility
Figure 5: ECB deposit facility where the extra liquidity is deposited on an overnight basis. Although it might appear that banks are hoarding cash, increasing levels of deposit facility usage is merely a sign of increased cash in the system. Banks who have accessed the ECB LTROs may have bought assets from other banks or lent to other nonfinancial borrowers but the end point for these funds would still be the ECB deposit facility. Hence why ECB President Draghi has said that the banks leaving funds at the ECB deposit facility are different to those borrowing cash at the LTRO i.e. the funds are being dispersed in the market. The problem now is will this cash be distributed to the wider economy. Source: ECB.