As Mario Draghi nears the end of his distinguished tour of duty as ECB president in October, his attention is turning to the monetary toolkit that he intends to bequeath to his successor. This toolkit can, and will, be augmented with modest reforms before he heads into the sunset. Whether these reforms will be radical enough to withstand the severe tests from the next European recession is entirely another matter.
The ECB’s recent shift in March towards more expansionary monetary policy is very much in the “business as usual” category. The governing council adjusted the gross domestic product and inflation forecasts downwards, while denying that this implied a greater tolerance for low inflation than previously reflected in their policy reaction function.
Given these changes, the ECB announced that policy rates would remain unchanged at least until the end of 2019, instead of mid year. This automatically extends the commitment to repurchase all the central bank’s maturing bonds by a further six months. And the governing council said that the expiring TLTROs (targeted longer-term refinancing operations) would be replaced by new ones later this year, while refraining from announcing the exact terms of these liquidity injections.
All these measures are part of the existing toolkit, but there are some nuances in the ECB’s latest thinking that might lead to important changes fairly soon.
ECB orthodoxy has generally held that the short-term profitability of the banking sector is not a concern that should prevent the central bank from using unconventional measures to ease monetary conditions. These measures include negative rates on banks’ deposits at the ECB, along with asset purchases and TLTROs that flatten the yield curve, the key determinant of banks’ operating profits. The governing council has usually argued that monetary stimulus benefits the banks via a stronger economy, and that this more than offsets any direct drags from the policy measures themselves.
Lately, there have been signs of greater concerns from senior governing council members, including Mario Draghi himself, that their future ability to ease monetary policy may be handicapped by the damage to banks’ profitability, which could undercut growth in private credit.
Somewhat surprisingly, President Draghi has sounded sympathetic to introducing a tiered system of negative rates on liquid deposits, similar to the mechanisms that already protect bank profitability in Japan and Switzerland. In effect, the “tax” from negative central bank rates would be reduced for banks holding excess reserves.
This idea remains controversial within the governing council, but Mr Draghi probably thinks it would give his successor the options of reducing rates further into negative territory or prolonging the duration of forward guidance about sub zero rates.
Tiered deposit rates could halve the €7.5bn hit to the banks from negative rates and add a modestly useful weapon for the governing council. But is it enough?
Because of the existence of physical bank notes, which automatically yield zero, the effective lower bound on policy rates is probably not far below the current minus 0.4 per cent, even with a tiered deposit system in operation. Furthermore, long-term rates are now so low throughout the eurozone that the scope to reduce them further via any form of unconventional policy — asset purchases, TLTROs or forward guidance — is very limited. Interest rate measures are therefore nearly at their limit.
What else might Mr Draghi contemplate before he leaves? There was a hint last week that he might try to follow the Fed’s example by edging up the effective inflation target, a move that might usefully increase inflation expectations. He emphasised that the target is symmetrical in the medium term around its central inflation objective of “below but close to 2 per cent”.
While he has said this before, many investors have assumed that the target actually involves a hard ceiling for inflation at 2 per cent, and the ECB’s historic failure to achieve even that objective has greatly added to scepticism.
It is probably too optimistic to expect any early change in the formal inflation objective. The EU treaties reduce flexibility by mandating price stability as the main purpose of the central bank, without explicitly mentioning employment or indeed anything similar to the Fed’s dual mandate.
Nevertheless, the governing council could clarify its existing target by emphasising that any period of low inflation will be followed by an equivalent period where inflation is allowed to exceed 2 per cent. This would allow average inflation to be on target over the medium term, similar to the price level target which might soon emerge in the US. But the markets may remain unconvinced that the governing council actually has the willingness and ability to deliver this in practice.
Throughout his tenure, Mario Draghi has been extremely adroit in reforming monetary policy within the framework of the EU treaties, while also retaining the broad confidence of the markets. But this has not been enough to keep consumer prices rising on the targeted track, even in good times for the economy.
When compared to the US Federal Reserve, the markets place far less credibility in the ECB’s inflation target. Although there are many weapons left in its arsenal, none of them seems powerful enough to overcome the constraints of the zero lower bound in the next recession. Furthermore, the likelihood that expansionary fiscal policy will be quickly activated when needed is much less in the eurozone than in America.
The Fed is now seriously considering its options to keep inflation on target in the next downturn. The new president of the ECB should do the same.
The ability of the ECB to ease monetary policy further is now severely constrained by the fact that interest rates are close to the zero lower bound right across the yield curve, not just in Germany but throughout the eurozone . . .
Despite aggressively easy monetary policy, break-even inflation expectations have been declining again, suggesting that the market is increasingly doubtful whether the ECB can achieve its inflation objectives. This is beginning to look more and more like the deflation trap in Japan . . .