Could Eurozone Pricing Issues Force the ECB's Hand?

Draghi was forced into several awkward comments following negative financials.

Apr 14, 2014 at 5:12PM

"We have to dispense with the question, 'Is there a deflation?' And the answer is, 'No.'"

Nearly two months have passed since European Central Bank President Mario Draghi made that declaration, but it may be time for him to rethink his words. European markets are once more hiccupping, and a recent drop in inflation rates in March could warrant policy action in the near future. Although ECB interest rates have been kept largely unchanged since the beginning of the year, Draghi notes that drastic changes may be on the horizon if inflation rates do not recover in April.

Considering the potential use of negative interest rates and Federal Reserve-like quantitative easing, these changes could put the ECB on untrodden (and rather slippery) ground. Normally the ECB takes a hands-off policy when it comes to handling market issues, preferring to exercise its powers to create monetary policy and let individual countries handle money supply issues. Because the ECB lacks the institutional power to regulate all eurozone money supplies, this has left the system with no effective policy options by which to address systemic money issues. 

A growing list of issues
Although inflation targets are set at a moderate 2%, the European economy has been struggling to hit the mark, with inflation rates falling to 0.5% in March. This is somewhat incongruous, considering the expansion of economic activity for the ninth month in a row. At the same time, despite increasing economic activity, businesses have not been growing their bottom lines; instead, they have been forced to cut prices, increasing volume of sales but losing profits anyway.

Unemployment is stable. Unfortunately, "stable" means staying at an average of 12% over the entire eurozone and remaining largely steady since peaking in 2008. This unemployment, coupled with lacking inflation levels, could lower market demands and create a self-sustaining cycle downward in the European market.

Counterintuitively, a strong euro is not helping matters. Although Draghi claims the ECB is paying close attention to the currency, a steady 12-month increase in the euro's value has threatened exporters by making imports relatively cheap by comparison. This will only complicate matters further and may destabilize economies if allowed to persist.

What can be done?
As mentioned above, the ECB is considering U.S.-style stimulus measures to support ailing economies. This would be markedly different from the bailout packages made in the past, as those were effectively transferring capital from a strong section of the eurozone to a weaker one. Instead, this would require the ECB to expand its powers to unilaterally push for increased money supply to purchase bonds without touching interest rates. Legally speaking, this would set a historic precedent, but it could be defined as an extension of monetary policy in order to avoid legal ramifications.

While adjusting interest rates has been discussed, some policymakers are nervous about using such a measure. They believe that lower, or even negative, interest rates would prompt capital flight from the EU. 

Even then, the ECB is hesitant to adopt such policies. With only a few national markets making structural reforms to combat the increasing threat of low inflation (or even deflation), Draghi may be dragging his feet to avoid rewarding more slow-acting economies with free money.

A forced hand for Draghi and US businesses?
Unfortunately, the economic markets may not give Draghi or the ECB too much time to decide on a course of action. The Federal Reserve's tapering of QE will only continue to pressure European markets, leaving important European industries (like auto manufacturing and technology) severely diminished and unable to compete with cheaper alternatives. Economists and investors are already preparing for a sharp increase in the euro, yet that increase could signal the beginning of EU market instability.

Such instability would, naturally, have overarching market concerns, but even if the ECB manages to minimize issues, there are several large U.S. companies that must tread carefully. For example, with more than 20% of total sales coming from Europe, General Electric and Coca-Cola (NYSE:KO) are rather overexposed in terms of debt to capital.

This is a particular concern for Coca-Cola, whose marginal downturn in U.S. sales has led to over-investment in overseas markets. Any tightening of fiscal policy or money supply in the EU could cause prices to fall, likely impacting the bottom line as consumers turn to cheaper domestic alternatives. Yet even if the EU goes through with quantitative easing, Coke could take a hit as prices rise across the board with the new money supply.

While Coke hardly reflects the circumstances of every American company invested in Europe, any money supply changes could have big impacts in the U.S.

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4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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