Central banks are once again playing the role of savior.
A renewed commitment from the European Central Bank to solving Europe’s sovereign-debt debacle and talk of further stimulus in the United States has lifted stocks—for now. But in the long run, the economic rescue effort may require more creative policies.
Last week, the Dow Jones Industrial Average closed above 13,000 for the first time since May 7. Investors cheered comments from ECB President Mario Draghi, who pledged that the ECB would do “whatever it takes” to preserve the euro. His comments were echoed by German Chancellor Angela Merkel and French President Francois Hollande, who issued a joint statement promising to exhaust all resources to stave off a breakup of the 17-country bloc. Meanwhile, in the U.S., the prevailing view is that the Federal Reserve will step in to stimulate the economy in the near term. With global central banks taking action, the stock market is likely to reap the benefits.
However, there’s some skepticism surrounding this view. After all, central banks have historically had difficulty sustaining stimulus momentum because lowering rates is often only a short-term solution. This is particularly true in developed markets, where not only interest rates but also growth rates are already very low. In fact, Moody’s issued a statement saying that cutting yields is only a temporary fix. The credit-ratings agency implored governments to explore other options, such as tackling debt levels and fundamental imbalances. The good news is that we’re starting to see signs of progress: Central bankers appear ready to use a wider range of policy tools.
For his part, Draghi made clear that the ECB is equipped to address widening sovereign spreads. He asserted that when yields on sovereign debt rise to a level that interferes with monetary policy, then it comes under the ECB’s purview. We expect the ECB to restart its dormant Securities Market Program and buy back sovereign bonds in the secondary market in order to achieve that goal. While in the near term this is a positive development, we believe the effectiveness of this tool over the longer term is questionable, given that 210 billion euros of purchases thus far have done little to reduce spreads.
But perhaps the ECB can do more, such as taking steps to become the lender of last resort. Ewald Nowotny, the head of Austria’s central bank, last week suggested that it might make sense to give the European Stability Mechanism a banking license. This could be interpreted as a solution the ECB is currently considering. In addition, Draghi called for appointing a euro-zone banking supervisor to help prevent a collapse of the interbanking market and renationalization of capital flows. Germany’s Merkel and France’s Hollande said that their countries are “bound by the deepest duty” to support the euro zone. While their comments demonstrate a deep commitment, it perhaps also suggests that a fresh approach is needed to succeed.
Similarly, Fed Chairman Ben Bernanke expressed his resolve in supporting the U.S. economy. When questioned by Congress about additional monetary-policy tools, he said that they could be additional securities purchases, an extension of the low-interest-rate environment beyond 2014, and, more interestingly, a cut on the interest rate the Fed pays banks on their excess reserves. Bernanke also confirmed that the Fed is considering using the discount window—a means for banks to borrow money from the government at a reduced rate—as a stimulative tool. While it could take many forms, some strategists believe it might resemble the Bank of England’s lending program, whereby banks could borrow at a low rate over the long term if they are willing to increase lending to companies and individuals. These policy tools could make a big difference by loosening credit, which remains tight despite recent improvements.
Since the 2008 financial crisis, accommodative monetary policy has not been able to stimulate the economy over the longer term, especially with many households and businesses unable to avail themselves of those low rates. Lowering the excess reserve interest rate and lending through the discount window at a low, long-term rate are intended to further incentivize banks to boost lending.
Together, these tools are hopefully enough to juice the economy over the longer term—and to restore faith among flocks of investors.