The European Central Bank has increased its stimulus package, but this may not be enough to increase growth and bring inflation back under control.
ECB stimulus initiatives
“The ECB is ready to do its part” said its President – Mario Draghi – in a speech on 15th February. On March 10th, the Bank did just that and took steps to ramp up its stimulus in the common currency area. Monetary easing was already underway in the Eurozone. In June 2014, the ECB became the first major central bank to push its deposit rate below zero.
The ECB announced a further cut to the deposit rate, bringing the rate down to -0.4%. Furthermore, it also reduced other interest rates and increased the size and scope of its quantitative easing (QE) program by announcing that it would start to purchase certain investment-grade corporate bonds.
Source: Wall Street Journal
In a conference call after the decision had been announced, Mr Draghi stated that the objectives of the new measures were to “reinforce the momentum of the euro area’s economic recovery” and to help inflation return to its target of close to, but below 2%. Inflation is currently negative in the Eurozone. In February, the headline inflation measure was -0.2%.
This reading may be partly due to low oil prices, but core inflation – which excludes food and energy products – was a mere 0.8% and well below the ECB’s target. This measure of inflation is preferred by policymakers who believe it is a better indicator of long-term inflation.
Negative rates risk
Negative inflation rates can depress growth as falling prices induce consumers to postpone purchases – a situation that Japan experienced for many years. In addition, when prices are rising, purchasing power is transferred from lenders to borrowers. Borrowers are effectively able to repay less than what they originally borrowed. But deflation increases the real value of debt. This is particularly problematic in the Eurozone where many countries have high debt burdens.
It is doubtful whether the ECB’s recent actions will be enough to mitigate these risks. In theory, the Bank’s measures should encourage other banks to increase lending and stimulate growth and inflation.
Negative deposit rates and QE were already in place before the meeting on 10th March, but growth and inflation have not really accelerated. The effectiveness of the former is limited as most banks have not passed them on to retail customers. There is also a risk that negative rates could erode banks’ margins which could force them to raise lending rates to avoid losses.
This has been the case in Switzerland. Like the ECB, the Swiss National Bank also has a negative deposit rate, but some Swiss banks have increased mortgage lending rates. The fragile recovery in the Eurozone could be undermined if banks in the currency bloc follow the same path as their Swiss counterparts and raise rates.
This is probably why Mr Draghi said that the ECB would be unlikely to reduce rates further at the press conference. This disappointed markets as stock prices fell while the Euro strengthened. A sustained rise in the Euro would mean that the ECB would find it difficult to use the exchange rate as a lever to encourage exports and bring inflation closer to its target.
Fiscal stimulus benefits
The other textbook solution to boost growth and inflation is a fiscal stimulus. In his press conference, Mr Draghi called for the Eurozone economies to “strive for a more growth-friendly composition of fiscal policies.”
More government spending should increase growth. It would also increase public debt levels, but a sustained increase in growth would also enable governments to benefit from higher tax revenues which could in turn be used to reduce deficits and debt. However, a fiscal stimulus might be politically unpopular in the Eurozone.
A more dramatic solution might be “helicopter money” – first proposed by the economist Milton Friedman. This involves a fiscal stimulus that is funded by the country’s central banks. This would effectively have the same effect as helicopters flying over a country and dropping bundles of cash.
While QE involves supplying banks with cash, helicopter money would involve putting cash directly into the hands of consumers who would then have an incentive to increase their spending on goods. Theoretically, this should boost growth and inflation. However, like negative rates, this policy has never been used before, so it may be risky to implement and difficult to rollback even if implemented.
Stimulus’ limited effectiveness
Even if more aggressive monetary policy measures are implemented, they may not be sufficient to influence the factors that affect long-term growth. The IMF called on policymakers to take steps on this front in its meeting last month – and Mr Draghi echoed this call in his press conference when he emphasized the need for structural reforms.
These are long-term measures targeted at improving factors such as productivity, the functioning of labour markets and the ease of doing business. These measures may not deliver results in the short-term, so the ECB may still continue to maintain low rates for an extended period.
It remains to be seen whether the Bank will be forced to resort to more innovative monetary policy measures. In the conference, Mr Draghi said that the ECB has not considered helicopter money.
Hence, for now, it appears that the ECB has done its part, as promised last month. It is now up to the banks and governments to do their parts – the former by increasing lending and the latter by implementing structural reforms.
