Broken transmission mechanisms

New figures from Europe reveal that both GDP and inflation in the euro area are falling, while unemployment is steadily rising. At its last policy meeting the European Central Bank reduced its main interest rate to 0.75%, a record low for the single-currency area. Yet low ECB rates aren’t having the desired effect around the struggling periphery.

Broken transmission mechanisms

«In 2008, as the euro zone started to contract, the ECB slashed its main rate from 4.25% to 1%. But because investors were worried about the state of the banks, the returns that banks had to offer on their own bonds rose. This offset the ECB’s easing, so that firms’ borrowing rates fell by less than normal.

When the euro crisis intensified in 2010, the ECB’s influence on interest rates in Spain and Italy waned even further. Banks’ bond yields rose in line with their governments’ cost of borrowing. As predicted by the bank-lending channel, but now as a result of a change that the ECB did not control, the supply of loans contracted. The amount of borrowing in Italy and Spain has started to fall again (see right-hand chart). Some of this may be due to weak demand. But a 2011 study by the ECB suggested that tight credit conditions could take two percentage points off annual growth in the currency area. Recent studies by the IMF and the Bank of Italy concur: credit supply is a big problem.»

Source: The Economist