Economic data in Europe is getting worse while inflation is low. Due to the varying situations of the economies of Germany and the periphery however, the European Central Bank (ECB) has to wait until 2013 to cut rates.
Markets were not impressed with last week’s events. The euro currency lost 0.5 percent to close at $1.2927, albeit still hovering around the $1.30 level. This is a level that both American and European exporters can live with, which is perhaps one of the reasons that central banks across the Atlantic have been relatively inactive recently.
Stocks were up 1 percent, with the EURO STOXX Index closing at 2,601 points. The Greek equity markets outperformed, rising 3.9 percent in the aftermath of yet another bailout.
The markets could have gotten another boost by a rate cut, but ECB President Mario Draghi chose to wait. He appealed to governments to address fiscal imbalances and left the main refinancing rate at 0.75 percent.
The ECB downgraded its growth and inflation outlook as well. At worst, a contraction of 0.9 percent will happen in 2013; at best we will see a 0.3 percent growth. Inflation could be between 1.1 and 2.1 percent, according to the Frankfurt-based central bank.
Reasons for the ECB’s Inaction
Given that the ECB’s main mandate is price stability, which is defined by an inflation rate around 2 percent, Draghi could have acted, especially because economic data continues to worsen. Industrial production in Germany fell by 2.6 percent in October compared to September; the third worst drop in the last 20 years.
Eurozone unemployment figures were also negative, especially for the under-25-year-old segment, which sits at a record 23.9 percent on the continent and the trend show no sign of reversal.
In theory, the ECB should provide some monetary easing, but it can’t at this point. The core nations around Germany are still doing relatively well, with positive data and negative data mixed in during the recent few months. The banks in these countries are flush with deposits and reserves and benefit from low rates, extending credit to consumers and companies.
Due to these low rates, German real estate prices have risen sharply over the last two years and the local media is already talking about a bubble. Further accommodation could worsen financial speculation in countries such as Germany, Finland, Austria, and the Netherlands.
On the other hand, banks in Spain, Italy, and Greece are undercapitalized. It does not matter much how low the refinancing rate is, as those banks are reluctant to lend given the uncertain economic outlook.
In addition, the ECB promises to buy bonds of troubled countries on the open market to stem the rise in yields, and this has kept those yields relatively low since the announcement of the program in September. It took pressure of governments to formally accept a bailout and activate this program.
The Week Ahead
The European Union will hold two meetings this week; one will include the finance ministers of the eurozone discussing the progress of the third Greek bailout.
The other one will see all heads of state and heads of government of the European Union come together to create a roadmap with respect to banking supervision and further the integration of a monetary union across Europe.
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