German Chancellor Angela Merkel and European Central Bank President Mario Draghi aren’t blinking yet.
The longest losing streak in European stocks in 11 years and the weakest inflation since 2009 has intensified pressure on the managers of the euro area’s already ailing economy to deliver fresh stimulus programs.
Battle-hardened by the debt crisis that almost broke the euro two years ago, policy makers are refusing to panic as they argue enough help is in the pipeline. The lesson of that last turmoil is nevertheless that investors may ultimately force action with taboo-busting quantitative easing from the ECB likely drawing closer as deflation fears intensify.
“The main story really is that the recovery is very weak, very fragile, and something has to happen,” said Martin Van Vliet, an economist at ING Groep NV in Amsterdam. “Markets are increasingly expecting they’ll have to do sovereign QE.”
The euro area is again at the epicenter of a global rout in financial markets as investors increasingly fret its toxic mix of weak growth and sliding inflation may become the norm elsewhere as central banks run out of ways to provide support.
With Europe straining amid tit-for-tat sanctions on Russia, Germany this week showing fresh signs that it is no longer immune to the slowdown in its neighbors. Confirmation Thursday that inflation slowed to just 0.3 percent in September helped drive down the Stoxx Europe 600 Index for an eighth day. Germany’s 10-year bond yield hit a record low.
For the moment, policy makers are holding to their view that the region needs time rather than new stimulus even with prices already shrinking in Italy, Spain, Greece, Slovakia and Slovenia.
“I think they’re surprised by the market correction,” Michael Schubert, an economist at Commerzbank AG in Frankfurt, said in a telephone interview. “They’ll be hoping this turmoil will pass on its own.”
Merkel, the leader of Europe’s largest economy, set the tone yesterday by telling lawmakers in Berlin that existing economic aid had been underused and now wasn’t the moment to ease up on the fiscal discipline she credits with bringing stability to the continent.
“It’s unsatisfactory that only a small portion” of the 6 billion euros ($7.7 billion) “provided for fighting youth unemployment have been disbursed” in the European Union, Merkel said. “We in Germany are showing that growth and investment can be strengthened without leaving the path of consolidation.”
That was a direct rebuff to countries such as France and Italy that advocate deficit spending in preference to the reforms Merkel would prefer they make to their budgets and labor markets. It may also annoy U.S. President Barack Obama’s administration after its Treasury Department said this week Germany needed to do more to boost “persistently weak” domestic demand for the good of global growth.
That’s criticism that was made throughout the debt crisis that spread from Greece, as the U.S. and others called on Germany to do more to stem the threat of contagion. In the end, Merkel didn’t stand in the way of Draghi unveiling a bond-buying plan to defend the euro.
Even after her government lowered its economic forecast for this year and next on Oct. 14, Merkel said the current environment cannot be compared with previous periods of market and economic turbulence, according to a party official.
“The crisis isn’t overcome in a lasting way,” Merkel said yesterday. “We have to pursue our efforts for sustainable growth, solid public finances and job creation resolutely.”
The ECB is also holding its course after cutting interest rates to a record low, offering banks new cheap loans and wrapping up a review of bank balance sheets. Such steps have helped drive down the euro, providing another source of stimulus if it bolsters demand for exports.
Having announced last month it would buy private-sector assets as soon as this month to provide the region with new liquidity in the hope of easing credit further, it has now agreed on a legal framework for buying so-called covered bonds, according to two euro-area officials.
The ECB’s Governing Council signed off this week on two acts to officially establish the program and detail its implementation, the people said. One of them said policy makers still need to agree on issues including accounting. Draghi set the end of this month as a deadline for purchases to start.
The ECB president last week acknowledged that boosting his institution’s balance sheet by buying assets or accepting collateral for loans was the last monetary policy option for him as he urged governments to do their part for growth by spending where they can and making their economies more flexible.
“The ECB still seems likely to sit tight in the near term,” said Howard Archer, chief European economist at IHS Global Insight in London. “The stimulative impact from the weaker euro, sharply lower oil prices and generally very low bond yields does give the ECB scope to hold fire on further measures for now.”
If the latest round of measures flop, Draghi will still come under renewed pressure from investors to start buying sovereign debt as other central banks have already done. So far he has limited himself to saying more unconventional policies could be deployed if needed.
A move to quantitative easing would put Draghi on a collision course with Germany as some of Merkel’s allies warn it would amount to the unacceptable monetary financing of governments and relieve pressure on politicians elsewhere in the region to shake up their economies.
“What Draghi needs in case full-blown QE has to be deployed is a sufficiently broad majority in the Governing Council,” said Marco Valli, chief euro zone economist at UniCredit Global Research in Milan. “It’d have to be a comfortable majority, and it’d have to enjoy some kind of implicit green light from Berlin.”
With inflation less than a quarter of the ECB’s goal of just below 2 percent and investors betting it will deteriorate further, such qualms might look misplaced. The theory is that QE would provide a kick-start to growth by pumping enough cash into the economy to ease credit, extend the euro’s slide and boost confidence in equity markets.
The risk is that it would fail and Draghi would be out of bullets, given the euro area lacks a U.S.-style unified debt market and bond yields are already low.
As a plunge in Greek bonds yesterday also served to remind investors of the debt woes at the start of this decade, Lena Komileva, chief economist at G Plus Economics Ltd. in London, said history shows policy makers eventually budge. Draghi has burnished his reputation as a man of action at the ECB by leading the fightback to save the euro with his 2012 promise to do “whatever it takes.”
“In the end, European policy makers always buckle and deliver,” said Komileva. “This financial shock may be the last push in a deflationary and recessionary trend that pushes the euro zone towards fresh stimulus.” [Bloomberg]