The European Central Bank decided to cut interest rates last week and reduced its main rate to 0.5 per cent. In its statement, the ECB said that it took its decision in response to inflation data, which now shows that inflation is well below the target level, and in response to rising unemployment. It was the first cut in 10 months.
That is as far as the news goes. However, this decision raises some considerations. Why did the ECB take this decision? What does it tell us about the ECB’s outlook of the eurozone economy? What message is it sending to the banking system and to governments? What are major world economies doing? What are the implications for Malta?
We need to encourage new activity without causing our economy to overheat
The statement of ECB president Mario Draghi had some very clear messages. He promised to provide as much liquidity as eurozone banks need well into next year and to help smaller companies get access to credit. He also said that the ECB is now “technically ready” to cut its deposit rate from the current zero per cent into negative territory, meaning it would start charging banks for holding their money overnight.
The broad economic scenario is that economic growth in the eurozone is expected to take hold only at the end of this year as unemployment hit a record high last March. So the ECB wants to ensure that its rather loose monetary policy reaches all corners of the eurozone and small- and medium-sized enterprises, which so far have been starved of credit, get access to the credit lines they require at a price they can afford.
Looking at major world economies, it is interesting to note what Japan is doing. Japan has been in a state of deflation for years, stretching into decades. It is a mature economy, similar to that of the eurozone. Whatever policies it tried, it has not managed to kick-start the economy again. Under its new Governor, the Bank of Japan is now aiming to double the monetary base in the country within two years to pull the country out of deflation. It is buying long-dated bonds for the first time and will cover 70 per cent of the budget deficit this year.
What the country wants to do is to generate growth by increasing domestic consumption through the so-called ‘wealth effect’ and by driving exports up by keeping the value of the Japanese yen down. Japan is not all bothered with its current level of public debt (around 240 per cent of the gross domestic product) given that it is also the world’s largest creditor. It just wants to inflate its economy.
And what about Malta? We certainly do not have the issues that a number of eurozone countries, or Japan, are facing. However, there is nothing to show that at some point in the future, we may not start to face unemployment issues if any of the companies operating in this country, or a chunk of economic activity, were to leave our shores. On the other hand, our inflation rate is above the eurozone average. We therefore need to encourage new activity without causing our economy to overheat. The low level of interest rates in the eurozone should be seen as an opportunity.
This means, however, that banks servicing the local market need to adjust their interest rates downwards in reaction to the ECB decision, at least for existing house loans and for commercial lending. This has not normally happened when the ECB reduced interest rates in the past. My comment is not meant to mean that there should be any government intervention in the banks’ decisions. Yet it does mean that we use whatever tools we may have to enable easier credit that would be channelled towards the creation of investment and jobs, without somehow stoking inflation.