Economists: ECB lowering interest rates insufficient to allow eurozone escape current crisis
25 March 2016. PenzaNews. Decreased interest rates and the expanded quantitative easing (QE) program are unlikely to help the European Central Bank (ECB) achieve its original inflation target of 2% and pull the eurozone out of the crisis, conclude economists Simon Tilford and Christian Odendahl, deputy director and chief economist at the Centre for European Reform respectively, in their article “Time for a regime change in Frankfurt” published in the foreign media.
The European Central Bank President Mario Draghi. Photo: Wikipedia.org
According to them, the press conference by the ECB President Mario Draghi held shortly after the central bank decision announcement attracted great attention from the market that had been greatly disappointed by the ongoing stagnation.
“The eurozone is not alone among developed economies in experiencing a structural growth slowdown in the rate of economic growth or in grappling with excessively low inflation. But the currency union does have an especially acute structural growth problem: it has only just recovered its pre-crisis size, a far worse performance than other developed economies, including Japan,” the analysts write.
In their opinion, this unsteady growth might transform into a deflation spiral, further spurned by investors’ disappointment in ECB’s performance.
“Weak economic growth is not the only reason for very low inflation in the eurozone. This also reflects the steep fall in oil and other commodity prices, but even stripping out these effects, inflation is far too low: core inflation, which excludes energy and food prices, has been stable at around below 1% for more than two years. The persistent weakness of inflation is being reflected in lower wage settlements,” Simon Tilford and Christian Odendahl explain.
The ECB bears the main burden for the current state of the monetary union, as it has persistently been too optimistic about the outlook of the eurozone growth and was too slow to cut interest rates, they point out.
“The central bank did eventually launch a major program of quantitative easing involving the purchase of a huge quantity of government debt. In the process, it kept a lid on government borrowing costs. But this has not shifted expectations of future inflation, partly because investors are unconvinced that the bank will not reverse monetary stimulus by selling government bonds as soon as inflation picks up a bit. In short, investors do not believe the ECB will do everything possible to meet its inflation target,” the experts of the Centre for European Reform state.
They also remind that the ECB had expected to boost the eurozone through growing global demand, but the plan ended up being impossible to execute due to weakening global economy and the shrinking value of world trade.
“The ECB had hoped that the euro would weaken sufficiently to raise inflation by boosting import prices. But the euro is stronger than the ECB would like, as the prospect of interest rate rises has receded in the US and UK, reducing the attractiveness of the dollar and sterling. And growth in emerging markets has slowed, putting their currencies under pressure,” the economists note.
According to them, the current excessively low inflation was created not just by the central bank, but also by financial policies of several eurozone states that are reluctant to step up their public investment for boosting demand and growth potential. At the same time, as the analysts suggest, the eurozone itself requires a big fiscal expansion and monetary stimulus, down to resorting to handing out cash directly to citizens if necessary.
“However, the ECB has consistently argued against fiscal expansion, at least in the absence of a fiscal union. The central bank has moderated its position a little recently, arguing for ‘growth-friendly’ fiscal consolidation, and some board members have even argued that countries with fiscal space to boost spending should use it,” Simon Tilford and Christian Odendahl write.
They come to a conclusion that the European Central Bank currently has several ways to boost inflation and growth, including deploying its current policies more aggressively.
“For example, it could lower the rate at which banks deposit their reserves at the central bank further into negative territory, to -0.75% (the rate prevailing in Switzerland) or even -1.25% (as in Sweden). The ECB could also apply negative interest rates to the loans it extends to banks. Such negative rates would make it less attractive to hold euros and assets denominated in euros. This, in turn, should weaken the single currency – helping eurozone exporters – and drive up inflation. If banks passed on their lower cost of funding to businesses, business investment would become cheaper to finance,” the economists think.
From their point of view, such negative rates are likely to stir controversy and increase pressure on banks by making deposit services less profitable, but could force large depositors to put their money to more active use and improve interest rates for business loans.
Moreover, according to the experts, an alternative solution to combat deflation is to further expand the QE program, extend its terms and broaden its scope to include corporate bonds, bank bonds and equities at once.
However, neither of the above measures would have the desired effect if the ECB does not manage to change investors’ expectations about the future course of monetary policy, they point out.
“Low interest rates alone will not lead to more investment if investors expect economic activity and hence inflation to remain weak. Inflation will rise only if consumers and investors expect that income and output will rise,” Simon Tilford and Christian Odendahl stress.
For a first step, in their opinion, the central bank must admit its failure to act in a timely and bold enough fashion in the past.
“The ECB cannot credibly claim to investors, banks and consumers that it has changed unless it puts its past behind it. Second, the ECB needs to make the overshooting of inflation central to its target. […] The ECB should commit to a price-level target, promising to reach 2% on average over a rolling period of five years. A period of lower inflation would automatically require higher inflation in the future,” the economists write.
Nevertheless, they come to a conclusion that Mario Draghi’s team will strive to avoid any radical shifts, and thus will be unlikely to pull the eurozone out of stagnation in the observable future.
“The ECB will only consider helicopter drops once there is absolutely no alternative, and only then if all other major central banks have already tried them. […] The most likely outcome of Thursday’s meeting is a gradual cut in the deposit rate, plus a limited extension of QE. When these measures fail to drive up inflation, there will be another gradual change in policy – but no regime change that is so crucial to changing expectations about the future path of inflation,” state the analysts of the Centre for European Reform.
On 10 March 2016, the ECB Executive Board announced the decision to cut its main refinancing rate from 0.05% to zero, as well as reduce its deposit rate from -0.3% to -0.4% and the marginal lending rate from 0.3% to 0.25%.
Moreover, the European Central Bank boosted its monthly bond purchases under the quantitative easing program from 60 billion to 80 billion euros starting from April, extended the QE measures into March 2017, and announced a new series of four targeted longer-term refinancing operations (TLTRO 2) from June 2016 at a minimal interest rate of -0.4%.
During the March 10 press conference, the ECB President Mario Draghi pointed towards a chance of introducing negative interest rates in the near future, but said that reducing rates further is not necessary at the moment.
The ECB’s decisions went far and beyond the experts’ estimations that expected the central bank to stop at adjusting the deposit rate and increasing the QE program up to 75 billion euros. However, a significant number of economists are skeptical over the changes and think that decreased interest rates may become a heavy burden for banks and insurers, while more quantitative easing is unlikely to have the same positive effect as back when it had been introduced in 2015.
In addition, some experts express their worries that Mario Draghi, who promised to do everything to save euro, ended up exhausting his list of measures that could boost recovery of the monetary union, pull the financial market back into the green zone and create the conditions required for strong inflation growth.