Throughout his eventful term at the helm of the European Central Bank, Mario Draghi has been a pioneer of intelligent reform. Even after his personal interventions brought the euro crisis under control, he has frequently been forced to combat chronic deflationary forces within the eurozone.
His response has been to construct a package of unconventional measures to ease ECB monetary policy, as interest rates headed into negative territory. He will bequeath to Christine Lagarde, his nominated successor, a battery of measures that looked inconceivable in the eurozone five years ago. The ECB is now a thoroughly modern central bank.
Next week, Mr Draghi will have his last chance to cement a dovish path for monetary policy until the end of 2020. But he is facing resistance from ECB hawks on the governing council, who are increasingly sceptical about the need for emergency action, and dubious about the effectiveness of unconventional monetary easing.
At his valedictory speech at Sintra, Portugal, on June 18, the president mapped out his latest plan. He claimed that the ECB still had plenty of monetary “ammunition” in the form of even more negative policy rates, along with dovish forward guidance about future rates and larger asset purchases.
He also emphasised that the inflation target of “below but close to 2 per cent” should be viewed as symmetrical, implying that there should be periods in the cycle when inflation exceeds these rates. Finally, he made a strong case that the EU should design a new fiscal mechanism to stimulate the economy in a severe downturn.
Following the Sintra speech, the ECB modestly enhanced its forward guidance on interest rates, and established internal committees to consider all other aspects of Mr Draghi’s proposals. There was an implicit promise of a much bigger package at the September meeting.
Since then, there has been no change in the downside risks to economic activity, or the persistence of below target inflation. Consequently, the market is expecting a very significant package next week.
Recently, however, there has been a counterblast from hawkish members of the governing council, led by Bundesbank president Jens Weidmann who was the disappointed candidate in the race to succeed Mr Draghi in the summer.
In a recent interview, Mr Weidmann said there was no need to panic about economic activity, and added (hawkishly) that any inflation rate between zero and 2 per cent would be consistent with the current formulation of the inflation target.
On monetary policy, the Bundesbank chief favoured further cuts in interest rates, arguing that the economy has not yet reached the “reversal rate”, at which further rate cuts become counterproductive by weakening credit from the banking sector. He also agreed with Mr Draghi that, in a severe recession, there should be more reliance on fiscal stimulus than any of his Bundesbank predecessors would have liked.
However, he was vehement in opposing the “monetisation” of budget deficits, implying that he would not want to endorse a new phase of large scale purchases of government bonds. He also said that major decisions on monetary policy should wait until Ms Lagarde is fully in post, hinting that any announcements next week should be relatively modest.
In the past, Mr Weidmann has often staked out a hawkish stance, only to support a dovish consensus driven by Mr Draghi at the meeting itself. Freed of any need to behave in a consensual manner now that he is no longer a candidate for the top ECB job, he may be more intransigent in future.
If so, the package that emerges next week may fall short of the scale the markets were expecting after the Sintra speech. The central bank’s key deposit rate may be cut only slightly, from -0.40 per cent to -0.50 per cent, while a small programme of asset purchases, at about €20bn a month for 6-9 months, may be announced. Forward guidance will certainly be strengthened with a great fanfare, but this seems increasingly irrelevant, since the market already believes that policy rates will anyway stay below zero for several years.
Finally, there may be a new programme of “tiered” central bank deposit rates similar to the schemes in Japan, Switzerland, Denmark and Sweden. This would cushion the costs to the banking sector from the further cut in the rate paid on overnight deposits held by banks at the ECB. Negative rates on these deposits acts such as a tax on the banking sector, which can be reduced by eliminating the negative rate on a proportion of excess reserves.
Although this could be a useful palliative for a temporary cut in policy rates into negative territory, Japanese experience indicates that it cannot realistically safeguard the banks against a permanent drop in the interest earned on their main assets, ie government bonds and corporate loans.
The only way of protecting the banks from this form of “Japanification” is to reduce the rates they pay on their main sources of funding. This means that households and small companies would need to earn negative rates, or pay charges, on their bank deposits. Neither central bankers nor government ministers seem ready to handle the political ramifications of such unpopular action.
Christine Lagarde’s evidence to the European Parliament last week suggests the incoming president will be happy with Mr Draghi’s modest parting gift. The economy may be sluggish but it is not facing an imminent crisis.
She firmly supported the need for highly accommodative monetary policy, but also warned that the impact of unconventional policies on financial stability would need to be examined carefully, and said that fiscal policy needs to play a more proactive role.
She clearly knows that she will face a severe challenge if a recession occurs on her watch. The ECB may have many shiny monetary weapons at its disposal, but their effectiveness is in doubt, and their side effects are becoming a constraint. In short, the ECB is beginning to resemble the Bank of Japan.