Monetary Policy Is Broken

Published by City Blaster on Fri, 03/05/2013 - 10:43 in
Draghi fear

Daily Market Commentary for May 3: With the US FED, the Bank of England and the Bank of Japan exhausting unconventional policy measures to drive their economies into growth, it is now time for the ECB to try some tricks. Negative deposit rates may be the next step.

The ECB cut its main interest rate from 0.75% to 0.50% in a widely expected move. Many have been the voices pressing the ECB to do something but the central bank has been avoiding it. Only after assisting to a deterioration in economic conditions in Germany the bank decided to cut on its key rate. More than that. Draghi not only cut the bank’s main rate but also said the central bank is studying the possibility of adopting a negative deposit rate for the first time in its history (even though others have done so in the past). If that happens, commercial banks would have to pay the ECB to park money overnight, in a move aiming at encouraging banks to lend the money instead of keeping it safe. These steps show the central bank is not tailored to manage the best interests of the EZ as a whole but rather Germany’s best interests, acting only when it is needed for that particular country. At the same time, it is a desperate move. A desperate attempt to substitute fiscal policy with monetary policy, an imperfect substitute.

The main problem with monetary policy is that its mechanisms are broken. Central banks around the world have been cutting on interest rates and enlarging the monetary base but the money supply is not growing at the expected pace. Commercial banks prefer to buy sovereigns and park the money at central banks instead of lending it to businesses and households thus undermining monetary policy dynamics. At the same time, businesses and households don’t want to borrow money as they aren’t confident enough with economic prospects. In this sense, cutting the interest rate, turning the deposit rate negative and even engaging in asset purchase programs may actually not work. The only solution for this problem lies in fiscal policy, which European governments have been using in the wrong direction, thus contributing to an open-ended recession and record unemployment levels.

Markets continue on the rise. It seems fear just vanished. I myself believe this is a reason to be concerned and I don’t recommend opening long positions on equity indexes when everybody is doing so. When retail investors enter the market massively, it is time to sell and go away. As for the Euro, this ECB intervention should weigh negatively and I expect the pound to revert part of the loss to the Euro it has registered over the last few months. A return to last year’s close at 0.8130 is highly possible.