Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The ECB surprised the markets this week with some aggressive moves but will they be effective in combating low inflation in the Eurozone? I’m here today with Bob Johnson our Director of Economic Analysis to take a closer look.
Bob, thanks for joining me.
Bob Johnson: Great to be here.
Glaser: Let's start with the European Central Bank. A surprise move from them this week. Can you tell us what they did and what they are really trying to accomplish here?
Johnson: Sure. They took a number of steps and this follows up from some steps they took this summer already, to really ease things off a little bit. And the reason they felt this is all necessary is because if you recall, their inflation rate on it, not a month-to-month, but a year-over-year basis came down to 0.3%, which is dangerously close to deflation. On top of it, their GDP growth in the second quarter came to a dead halt after kind of three quarters of at least some improvement off of the recession which kind of stalled out again.
So, that's got them very worried and today, they came out with guns blazing. They cut a couple of key interest rates; the overnight lending rate they cut. On the other hand – on the other side I should say, bank money that is held at the central bank as a reserve, they're now charging a negative 0.2% instead of a negative 0.1%. That certainly encourages banks to lend out the money rather than pay kind of a penalty fee, if you will.
So, those are all steps – each one of them normally would have been considered a big step, but really, combined, it's pretty powerful. And on top of it, they announced they'd buy some asset-backed securities and some covered bonds as well, which would – which, in essence, encourages corporate lending and encourages businesses to borrow. So, those are all things meant to stimulate the economy.
And it follows up, as I said, moves earlier this summer, some of which hadn't even been implemented yet. There were some lending programs that were going to kick in this month and next month and we hadn't even seen the results, but things got so dire that I think they had to move a little bit faster.
Glaser: With these moves, ECB head, Mario Draghi says that rates are now basically at their lower bound, their asset purchases are kind of constrained by some political and charter issues that can't buy sovereign debt like they did in the U.K. – excuse me, in the U.S. So, the question is, is this enough? Will this actually work? Or is the ECB really just doing all they can, but it's not going to make a big dent?
Johnson: They're doing everything that they can and as you mentioned, they do have structural limits. Although, I will say that they've said about two times earlier that we've reached the lower bound and somehow they managed to keep on finding a little bit more in their pocket.
But I really think there isn't a lot left. I think this will help. And the mechanism where all of this really helps – it's a little different in the U.S. market where the low rate is meant to kind of stimulate assets and encourage the housing market. Here, what it really does is pushes the euro lower and makes European goods more competitive in the rest of the world, and that's a real benefit that we'll get from all of this. The euro was pushing 1.5 to the U.S. dollar, today it closed below its historic – kind of at a historic point at 1.3. And you know what, there are some analysts out there, I don't know that I agree, they think it will be back to parity in two or three years.
So, clearly the euro has come back and that will make them more competitive. That is a piece of the good news for them.
Now on the other hand, the other thing that you've got working is that what the Central Bank is trying to do is buy time, so that structural reforms that we need get made, and so far they haven't been made. France's tax policies probably clearly need to be changed; Italy probably has some labor reforms and some other things that they need to do that they haven't taken action on yet and even Germany, yes, they are doing very well, thank you. But their own internal demand is not so high and they could do more to stimulate that which would help the rest of the union.
Glaser: The Bank of England, we heard from them this week as well, the U.K. is growing at much faster rate than the Eurozone. Are they still on track to raise rates potentially early next year?
Johnson: Everybody is watching the U.K. real closely, because they've been particularly strong. Their economy, I think, grew as much as 3.5%. So clearly a pretty nice rate of growth there and they are worried about when will the withdrawal come. And today they met and they decided to hold steady for now and said, you know what, the one other thing we're watching is inflation adjusted wages, and those haven't done much yet, so people are thinking, well, maybe we got a little lease on life here and we'll get a few more months of low rates out of the U.K.
But they've also engaged in the quantitative easing program because they have their own currency, as does the U.S., so they've got a little bit more flexibility and they've really used it. And their economy is beginning to heat up, especially the housing market in London, and so that's starting to cause some pressures to raise rates, and I think they will go first and when they go first and people will be quickly asking how soon will the U.S. fed follow soon?
Glaser: The Bank of Japan has been very aggressive as well. We got a little bit of data from them. What do you expect them to do with their upcoming meeting?
Johnson: They are meeting on the 9th, and there is some economic forecasts that go underneath all of this and they continue to think that the stimulus that they've all put in place is slowly working. I'm not so sure that I believe that, but – because working across purposes they raise their consumption tax pretty drastically and that certainly had a huge impact on the second quarter, and the July numbers don't look a lot better yet, but they are holding the faith and they are going to continue with their current policies based on the data and forecast that they released today.
Glaser: How does this impact the United States though and the Fed, Janet Yellen or rest of the Board, how much they consider what these other banks are doing when setting their policy rate, are they really just looking at what's happening with the economic data here in the United States?
Johnson: I mean, I think the formal chatter is to really watch what's happening in the U.S. and adjust for U.S. inflation and labor rates all at the same time. And I think they'll continue to watch the labor data very, very closely.
On the other hand, the rest of the world is falling apart. I think, it kind of will be self-defeating to world economy for them to drastically raise rates and all of a sudden – that doesn't help the rest of the world, if our demand goes down. Right now, we are the main engine in town. The U.S. economy is very strong. We can talk more about that later, but the U.S. economy really is the engine for a lot of things to come out of recession and we certainly begun to see that in some categories.
Glaser: Let's look at that strength then. What data have we seen recently that you think could lead to the Fed maybe raising rates or think be more comfortable with raising rates next year?
Johnson: Yeah. Well, again, they are watching the labor market. So we'll see what happens with the employment report later this week and some of the other data what the hourly wage did and so forth. So those are all going to be important things. But just looking at the overall strength of the economy, labor market or not, the ISM Services Index released on Thursday showed a pretty dramatic increase and everybody thought it was going to go down. Auto sales which people thought going to be, well, will go from 16.4 to 16.6 in August, they went to 17.5.
I mean, again these numbers can all be adjusted. We know the danger of watching individual numbers, but these are kind of on-fire type of numbers. And so I think they are bullish about the U.S. economy and suggest that maybe rates here will be going up sooner than later.
The Fed will meet next week and I think they'll just reaffirm that the bond buying stuff is all done, it was already scheduled to kind of – and said we're going to put wraps on October and I think that will be finalized at the meeting. But I still think they are going to be very, very, very vague about when they are going to begin raising rates. And as I've said many times, I really don't care if it is February or if it is October I think rates belong slightly higher, but for a lot of the reasons we've talked about again and again less corporate demand, aging baby boomers, lower inflation rates that I am not expecting a big boom in interest rates. Yes, I expect them to move higher, but not the kind of destructive doubling in rates that we've seen in other recoveries.
Glaser: Bob, I certainly appreciate your analysis on what's happening with Central Banks today.
Johnson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
