What the monetary policy in Europe needs to address
On October 9, 2014, the ECB (European Central Bank) chief, Mario Draghi, gave a speech at the Brookings Institution in Washington. He observed that since European banks have been largely engaged in lowering their loan-to-deposit ratios and rebuilding their capital, they have not been in a position to pass on low interest rates to customers.
The monetary policy thus needs to act on two fronts:
- Work on an expansionary stance to combat conditions of low inflation and substantial slack in the economy.
- Repair the transmission process of monetary policy, so that this stance actually reaches firms and households.
ECB’s monetary policy measures
Draghi took this opportunity to highlight the role that the ECB has played with regard to the monetary policy in two ways. First, the ECB has progressively cut rates, going even into negative territory, so that they are now at the lower bound. Second, the ECB has introduced forward guidance that rates will stay low for a long time.
ECB’s new package of credit easing measures
Along with the above measures to ensure that the benefits of the monetary policy repair will reach firms and households, the ECB has undertaken an additional package of credit easing measures:
- The targeted long-term refinancing operations (TLTRO), which have a built-in incentive mechanism to encourage loans to firms.
- New programs to purchase outright high-quality ABS and covered bonds, which will provide market incentives for banks to originate more salable securities, and thus more loans to collateralize them.
With the introduction of such credit easing measures, the ECB intends to revive lending, and thus, growth and economic activity in the European economy. An uplift in economic activity in Europe bodes well for U.S. exchange-traded funds like the iShares MSCI EAFE (EFA), the iShares MSCI EMU (EZU), and the Vanguard FTSE Europe ETF (VGK), which track European equities.
These funds have largely underperformed U.S. equity funds like the SPDR S&P 500 (SPY) and the Core S&P 500 ETF (IVV) over the last 5 years. The EFA, EZU, and VGK have gained or lost, 7.47%, -8.76%, and 0.80%, respectively, from October 2009 to October 2014. At the same time, SPY and IVV have gained 72.11% and 72.59%, respectively.