It looks like it didn’t take long for Mario Draghi to settle in as the new President of the European Central Bank (ECB). In his first ECB rate statement as the central bank head, Draghi surprised the markets with an unexpected rate cut, the first the euro zone had seen in over 18 months. Talk about starting your term off with a bang!
In a unanimous decision, ECB officials went all ninja on the markets and voted to slash its benchmark interest rate from 1.50% to 1.25%. While it’s true that many had expected some sort of easing somewhere down the line, few had believed that the ECB would cut rates so soon into Draghi’s term.
The ECB caught almost everyone off guard as it defied the expectations of 49 out of 55 economists who had predicted no change in interest rates in a recent Bloomberg survey.
Nothing but dark clouds ahead
In the ECB rate statement, Draghi had very few positive things to say about the economy. With the way things have been going, he sees a “mild recession” looming just around the corner. He even said that the central bank will probably have to revise its growth forecasts downwards when it submits its new growth projections next month.
But really, can we blame him for being so pessimistic? Recent data from the euro zone hasn’t exactly been upbeat. In October alone, we witnessed some pretty lackluster reports. The manufacturing industry recorded its third monthly decline and German unemployment rose for the first time in over two years.
Weapon of choice: rate cuts
From the looks of it, the European economy could be in for more easing in the months to come. But since Draghi didn’t sound too enthusiastic about using bond purchases to lower borrowing rates and boost the economy, interest rate cuts will probably be the ECB’s weapon of choice.
He described the ECB’s bond purchasing program as “temporary” and “limited,” adding that it will probably just be used to support its rate decisions. I don’t know about you, but I take this as a sign that Draghi will continue to use interest rate adjustments as his first line of defense.
Heck, some analysts say that we may even enter 2012 with the benchmark interest rate at 1.00%. It doesn’t seem like high inflation, which is still at 3.0%, a full percentage point above the ECB’s target, will stop the ECB from slashing rates. Draghi has made it pretty clear that the central bank prioritizes economic growth above inflationary threats.
Eyes on the euro
If not for the announcement that Greece had abandoned its plan for a referendum on the EU debt deal, the euro might have ended much weaker yesterday. But just because it was able to stave off a big sell-off yesterday doesn’t mean that it’s in the clear.
Changes in interest rate differentials don’t come often, and what we witnessed yesterday was the type of development that could have long-term effects on the euro. Though it may not sound like much, the unexpected 0.25% drop in interest rates could cause investors to slowly dump the euro to seek out higher-yielding assets over an extended period of time.
I would keep my eye on the euro for the time being. To me, it seems that the only thing propping it up right now is hope that the EU rescue package will finally be ironed out. But ask yourselves this: once all this hype has died down, what will keep the euro up?
With such a grim outlook for monetary policy and debt contagion threats still lingering, it may be just be a matter of time before the euro turns south again.