ECB in a Holding Pattern
The managing director of the International Monetary Fund, Christine Lagarde, has issued a stern warning about the growing dangers of deflation. In a speech in Washington on January 15, she said that falling prices “could prove disastrous for the recovery.” Lagarde picks up a topic that has worried many Europe observers for months: a fall in lending to households and non-financial corporations, and an inflation rate that now appears to be stuck well below 2 percent, the official ECB inflation target. The specter of a lost “Japanese” decade of falling prices, shrinking economic activity, and growing levels of debt has prompted speculation among many investors about forthcoming action by the ECB.
Just before Christmas, I heard a senior European official who seemed to confirm that view. He suggested that the ECB was ready to launch a program that would mirror the funding for lending scheme undertaken by the Bank of England in order to spur bank lending to the real economy. According to many media reports, the latest press conference by the president of the ECB, Mario Draghi, provided further proof that the central bank is getting “ready to act.”
I beg to differ. For all those who think that inflation in the euro zone below 1 percent is a trigger for a further rate cut or a new liquidity program for banks or a euro area specific program of asset purchases—commonly known in the United States as quantitative easing, i.e., QE— I would like to offer an alternative analysis.
Draghi said that, despite the latest data, he still views inflation expectations well anchored at or just below 2 percent in the medium term. Executive board member Benoît Coeuré told Bloomberg News that the common definition of medium-term is about 18 months, but in the common currency area, “the path through which inflation reverts back to the 2 percent number depends on the nature of the shock and the type of nominal rigidities that you have in the economy. […] That is compounded by the fact that a number of European countries are going through a relative price adjustment, which is a necessary adjustment, since it’s part of regaining competitiveness.” In other words, no need to act any time soon, unless of course conditions deteriorate dramatically.
If inflation is not the trigger for further action in the present conditions, what could be?
Draghi cited possible disruptions in money markets. Coeuré explained that stability of money markets could be adversely affected by the way investors react to the further tapering of asset purchases by the Federal Reserve. However, he was also quick to point out that in a fixed rate full allotment regime, the ECB already provides liquidity to counter short-term shocks. Banks are already moving away from reliance on the longer term refinancing operations to main refinancing operations, from long-term to short-term ECB liquidity. He added: “The power of that instrument (MRO) is sometimes not appreciated by the market.” In other and simpler words, the ECB does not need new tools to address potential money market disruptions as long as they are not protracted in time.
As if this was not enough to discourage expectations that the central bank is close to acting, Coeuré buried the idea that the ECB might use a tool similar to the funding for lending scheme in Britain that links the provision of the central bank’s liquidity to specific conditions, such as enhanced bank lending. The European central banker made clear that, in order for such a program in the euro area to be effective, “you have to make the case that the primary obstacle that banks are facing when they lend to the real economy is lack of access to liquidity.”
Well, that’s evidently not the case at the moment, is it?
What we are left with is an ECB that in 2014 will be more focused on its future role as single supervisor of banks. The credibility of the ECB now primarily rests on making sure that the comprehensive balance sheet assessment it is undertaking with the European Banking Authority is thorough and successful.
Monetary policy is retreating into a temporary shell disguised by its “forward guidance.” The ECB is talking easing – i.e. confirm that interest rates will remain low for a protracted period of time – rather than deploying new tools. I expect the ECB to be reactive rather than active. Of course, if in the coming weeks the German Constitutional Court rules that German participation to the most successful ECB policy tool, the sovereign bond-buying program known as Outright Monetary Transactions (OMT), needs to be limited, all bets are off. Let’s only hope it won’t come to that.