Monetary stimulus works until it doesn’t, as Japan discovered during the deflation that began in the 1990s. Europe is the new Japan, and the United States is getting there fast.
European Central Bank Chairman Mario Draghi announced on Thursday a new long-term lending facility for European banks and promised not to raise interest rates for the next year. Equities rose before the announcement and plunged afterward. European banks, autos and basic resources performed worst. The SX7E Index of major European banks lost 3.5%.
After nearly four years of negative short-term interest rates, the ECB is out of ammunition. Negative interest rates are doing more harm than good, for example, by forcing Germans to increase savings at the expense of consumption, which depresses economic activity. Negative interest rates also suck deposits out of the banking system, reducing bank profitability. European savers have a form of the Red Queen problem in Alice in Wonderland, where the Queen has to run faster in order to stay where she is.
When monetary stimulus becomes the cause of economic weakness, the central bank is out of bullets. Fiscal stimulus might help in the form of supply-side tax cuts and deregulation, but every one of the big European countries suffers from policy paralysis. The social democratic left—including the British Labour Party, Germany’s Social Democratic Party, and Italy’s Democratic Party (PD)—has lurched to the left. In Germany, where Angela Merkel’s Christian Union governs in coalition with the SPD, that excludes any political consensus over fiscal stimulus.
That leaves monetary policy, which is broken. Draghi announced a new Targeted Long Term Refinancing Operation under which the ECB will lend banks up to 30% of the value of certain business loans. Most of that simply rolls over some 720 billion Euro of existing ECB loans to banks.
The German 10-year inflation-protected bond yield fell 7 basis points to -1.24%, barely above where it stood last June when panic over Italy’s budget prompted panic buying of ultra-safe assets.
This points to a weaker opening for Asia, where Chinese A-shares have been the market leader year to date. As I said yesterday, equities are hitting a rough patch.