The European Central Bank’s response to Covid-19’s devastation of the European economy has been both swift and substantial. But what does it all mean and how will it impact you?
At its regular monetary policy meeting on March 12th, the central bank made it much easier for banks to lend by re-introducing what it calls "targeted longer term refinancing operations" (TLTROs). These are very low interest loans from the ECB to banks like AIB and the Bank of Ireland, designed to incentivise lending to families and firms.
The more they lend to us, the lower the interest rate they pay and so the lower the interest rate they can charge to us. In fact, banks can now borrow from the ECB at a negative rate of 0.75 per cent.
In other words, the ECB is paying banks to take out loans so that they will lend on to companies and households to keep the real economy alive. It’s a form of life support, tailored to get us through the crisis.
It’s important to note, however, that this credit facility does not include mortgages.
Of course, for this action to work, the banks must pass on these super low interest rate loans to families and to small and medium-sized enterprises most affected by Covid-19. Time will tell whether the Irish banks will rise to that challenge.
Quantitative easing
Quantitative easing (QE) or net asset purchases, as the ECB prefers to call it, has been in place since before the crisis, with monthly asset purchases of €20 billion since November 2019. The policy objective here was to push price inflation in the euro zone towards 2 per cent, the ECB's overarching monetary policy objective.
On March 12th, the ECB said that, in response to the economic impact of Covid-19, it would bump up QE and buy additional net assets of €120 billion until the end of the year.
QE works through a number of channels. For example, the ECB buys government and private sector bonds from banks, pension funds and insurance companies by electronically putting money into their bank accounts in return for bonds. The rising demand for bonds increases the price and reduces the yields, or effective interest rate, on those bonds (as the price of a bond rises, the yield you can get from it declines).
In tandem, businesses use the money they receive from the ECB to purchase other financial assets like company shares and bonds. These purchases fuel price rises too, which pushes down on yields more generally.
As a consequence, interest rates should fall across the euro economy, allowing businesses and consumers to borrow more cheaply.
The low interest rate environment should also push banks to lend to more businesses to earn higher returns on loans than they could pick up elsewhere. So, with cheaper and greater lending, as the lockdown eases, businesses will be able to hit the ground running.
Crucially, QE pushes down yields on government debt. This is especially important in the context of Covid-19, as it helps to reduce the growing national debt burden. Exchequers across the EU are going deep into the red to fund the enormous fiscal stimuluses that have been announced.
Communication, or "signalling" as the markets call it, is key to the success of QE. ECB president Christine Lagarde made a serious mistake during her press conference on March 12th. She confused markets by saying it was not the ECB's role to "close the spread" in sovereign debt markets.
She was referring to the difference in yields between relatively safe German debt and relatively risky Italian debt. The reality, however, is that it is unequivocally the role of QE to reduce yields on government debt.
Her comments led to a sell-off in Italian bonds, driving Italian yields higher. This was the last thing the ECB wanted. She has since apologised and the bank has come out with an even greater stimulus package, saying it will do everything necessary within its mandate to support the European economy in this time of crisis.
Emergency programme
On March 18th, the ECB launched the Pandemic Emergency Purchase Programme. This is a €750 billion QE programme, which will last to the end of the year, and involves the purchase of both private and public sector assets. And the ECB has made clear that there is more money, much more, available if needed.
The bank insists it will explore all options to support the economy through this shock so that “all sectors of the economy can benefit from supportive financing conditions that enable them to absorb this shock . . . including families, firms, banks and governments”.
The ECB is keeping the European economy on life support as its circuits have temporarily shut down. Let’s hope it works and that Irish banks, in particular, play their role in passing on this vital support to Irish families and firms.
Marie Finnegan is a lecturer in economics in the School of Business at GMIT
