Monetary stimulus tools run up against obstacle in troubled banks, impact may be limited

FRANKFURT – Investors and analysts are nearly certain: The European Central Bank will take action at its next meeting to boost the tepid recovery.

What’s not at all certain is how much good that can do.

Any help is needed. The weak recovery in the 18 countries that use the euro is a source of risk and uncertainty for the rebounding U.S and global economy. The eurozone economy grew only 0.2 per cent in the first quarter, gaining no speed from the quarter before. Worse, inflation is dangerously low at an annual 0.7 per cent, well below the ECB’s goal of just under 2 per cent.

A long period of low inflation is a threat because it makes it harder for heavily indebted governments to cut their borrowings, and increases the pressure on them to keep imposing fiscal austerity in the form of higher taxes and restrained spending, which slow growth further.

Yet economists say the impact of most of the measures that are being talked about would likely be a marginal improvement and psychological reassurance, rather than a big bang.

Holger Schmieding, chief economist at Berenberg Bank in London, said the biggest impact may be to show that the ECB is willing and able to act.

Short of a complete surprise, such as a massive program to boost the amount of money in the economy through bond purchases, “what the ECB will do will have only very modest consequences.”

At the ECB’s last meeting in May, Draghi said the bank was “comfortable taking action next time,” on June 5. Economists are taking him at his word, and so are foreign exchange markets. The euro has fallen 3 full cents since then and for now has stayed lower, trading below $1.37 Friday in anticipation of an interest rate cut, the most likely move.

The ECB could also offer more cheap credit for banks, perhaps on the condition that they loan it to small businesses. Or it could take the bolder move of starting bond purchases — an unprecedented step for the ECB but one the U.S. Federal Reserve has taken with arguable success to drive down market interest rates for companies and consumers.

Here are some of the reasons why economists are skeptical how much impact ECB action will have.

CLOGGED BANKS: The benchmark refinancing rate is already at a record low of 0.25 per cent. The rate determines what it costs banks to borrow from the ECB, and strongly influences the rate at which banks lend to each other. Through them — the so-called “bank channel” — the ECB in theory controls the rates businesses pay for loans to expand their plants, or on what consumers pay for mortgages.

Yet rates are already very low.

And, more important, the bank channel is clogged.

Banks with troubled finances aren’t passing on the low rates. The ECB is trying to improve confidence in the banks by reviewing their finances — and forcing the ones that are hiding losses to raise new capital, or even be sold or restructured. Economists say completing the review and straightening out the banks are the real key to getting the eurozone economy hitting on all cylinders. The review won’t be done until this fall.

Meanwhile Analyst Carsten Brzeski at ING says a conventional rate cut and other measures will have “hardly any” effect on growth. He says that’s probably why the bank hasn’t cut rates since Nov. 13, despite promising every month to act if needed: “If it was the silver bullet, they would have done it already. “

GO NEGATIVE: Another unconventional step discussed for months is a negative rate on money banks leave on deposit with the ECB — charging them for hoarding money in an attempt to push them to lend it out.

But it could backfire. Banks could pass the cost on to customers — the opposite of what the ECB is trying to do.

BLOWBACK: A key factor weighing on inflation and growth is the strong euro, which hurts exports and makes imports expensive. Low rates in theory push down the euro by reducing returns on interest-bearing investments and therefore demand for the currency.

But measures that improve prospects for the growth would also attract more investment — and tend to push the euro up.

THE BIG KAHUNA: Bond purchases — a less likely option — would aim to drive bond prices up and their interest yields down, in hopes that those lower bond yields would be reflected in lower rates for other kinds of borrowing.

Problem is, eurozone bonds have already risen recently, and yields are low.

That means any bond purchases would have less impact than they would have two years ago, at the height of the debt crisis.

Despite questions about impact Schmieding says the bank has to act. “With what Draghi has said, if he does nothing, his trust and credibility, his communication strategy, will suffer a lot,” Schmieding said.

“So he’d better come up with something — if it has a lot of impact or not.”