Don't expect miracles from central bankers
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Jeremy Glaser is the markets editor with Morningstar US.
Recently it seems the world's economic hopes are in central bankers' hands. The market hangs on every word that comes from the Federal Reserve and the European Central Bank (ECB), hoping to hear some hint that another round of monetary stimulus is coming down the pike.
This intense focus on the central banks is not entirely surprising. Given how sclerotic the political process has been in Europe and the United States, investors are turning to the semiautonomous entities to give the global economy a push.
Certainly, good monetary policy is crucial to getting the economy back on more solid footing. But it alone is not sufficient. Reasonable fiscal policy and some painful corrections are needed, as well. Anyone hoping for a monetary policy miracle will likely find themselves disappointed.
How much firepower does the ECB have?
So more than four years after the financial crisis, what can the banks do now? The answer is somewhat different on each side of the Atlantic. The Europeans have a stronger claim that their central bank can be transformative in turning around the economy. The ECB has more policy options at its disposable that can plausibly make a difference. But just because they can be useful doesn't mean they alone can solve Europe's woes or bring the continent back to growth.
The most immediate action the bank is likely to take would be to buy sovereign debt on the open market to help bring down the yields. ECB president Mario Draghi indicated several days ago that the bank is close to doing this in the next couple of weeks. This is a potentially vital operation. Spain in particular has had troubling high 10- and two-year yields recently well more than 7 per cent.
At this level, it becomes increasingly difficult for the country to roll over expiring debt, and it further exacerbates the country's sovereign debt problems. The ECB has the firepower to buy enough bonds in the marketplace to send this rate back down to earth and give Spain some breathing room. However, the bond buying will do only that, create some time and space to tackle the underlying issues.
Artificially lowering the yield won't magically eliminate Spain's underlying troubles. The country still needs to tackle its competitiveness problem, create a realistic budget, and decrease unemployment among other issues. ECB action will help, but there will need to be political follow-though to finish the job.
Similarly, the ECB will likely play a major role in stabilising Europe's fragile banking system. The central bank is needed to provide the liquidity that will be crucial in allowing the financial institutions to clean up their balance sheets and prepare themselves for lending again. But the banks actually have to use the opportunity to accept losses and not just use the added liquidity to continue denying reality. In other words, the ECB can yet again be helpful, but it alone won't solve the crisis.
There are of course other things the ECB can do to set the stage for growth. Key rates could be lowered more, and the bank could pursue other unconventional monetary policy. However, investors hoping the bank is going to pull a lot more arrows out of its quiver are going to be disappointed. The ECB has fought hard for its institutional independence, but it isn't free to do whatever it wants outside of a political vacuum.