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Time to act

4 November 2013 By Hugo Dixon

The case for looser monetary policy should be clear when the European Central Bank governing council convenes in Frankfurt on Thursday. The question is what tools to use: lower interest rates, spraying the banks with more cheap long-term money or the ECB’s first dose of “quantitative easing”. The answer should be a mixture of all three.

Mind you, there are enough inflation hawks inside the governing council that it’s not certain it will even agree that more needs to be done. Some central bankers may argue monetary policy is already loose enough. After all, the ECB’s main interest rate is 0.5 percent and back in July the central bank said, in its first experiment with “forward guidance”, that it expected interest rates to “remain at present or lower levels for an extended period of time”.

What’s more, the euro zone is gradually recovering. In the second quarter, GDP rose 0.3 percent compared to the previous three months. As if this were not enough, Germany’s Bundesbank has started warning that property prices are getting overvalued in some German cities. Why stoke an emerging bubble with still cheaper money?

There are two answers to these points. First, the ECB’s monetary policy should look to the needs of the euro zone as a whole, not just at what is happening in a few German cities. Insofar as the Bundesbank is concerned about a property boom at home, it should advise the German authorities to tell banks to curb their mortgage lending in those areas prone to inflation. There’s no need to deny the rest of the euro zone a looser monetary policy.

The second answer is that the euro zone’s recovery is anaemic. As Mario Draghi, the ECB president, put it last month, the governing council itself views the recovery “as weak, as fragile, as uneven”.

There are several problems. One is that credit flows are, in Draghi’s words, “very weak”. Another is that the appreciation of the exchange rate will make it harder for European companies to enjoy export-led growth. Ten days ago, the euro rose to $1.38 – a near two-year high – before slipping back on expectations of a rate cut.

If inflation was also high, the ECB might be justified in taking no further action. But it’s not. Eurostat’s flash estimate for October was just 0.7 percent, down from 1.1 percent the previous month. Every month this year, inflation has been 2 percent or less.

The drop in inflation is partly due to falling energy prices and fewer hikes of indirect taxes by governments. But the still depressed economy is also to blame, as is the strong exchange rate.

Given the slack in the economy, especially the high unemployment, there seems little risk of inflation shooting up. Draghi himself said last month: “We see inflation as remaining subdued on the very low side of 2 percent, and we see this as extending into the medium term.” Given that the ECB’s mandate is to keep inflation below but close to 2 percent, it is failing to do its job.

In September, inflation was above 2 percent in only two of the euro zone’s 17 countries, the Netherlands and Estonia. It was negative in Greece, and in Latvia, which is to join the single currency in 2014.

A looser monetary policy might push inflation in other countries, such as Germany, above 2 percent. But this would be a good thing. The Germans are fond of lecturing peripheral countries, such as Greece, on how important it is to cut their prices to restore their competitiveness. The corollary, if the ECB is to hit its target, is that inflation elsewhere has to be higher.

What then are the best tools for the ECB to use? Shaving another quarter of a percentage point off its main interest rate, to bring it down to 0.25 percent, is the obvious first step. But it won’t achieve much and, after that, the ECB will have exhausted its conventional arsenal.

Fortunately, the central bank has unconventional tools too. In Draghi’s words, “we have a vast array of instruments”. Two, in particular, come to mind.

The first is the so-called long-term refinancing operation. This involves lending cheap long-term money to banks. The ECB lent 1 trillion euros two years ago in this way, to keep the banks afloat. Much has been repaid. But given that the rest is due to be repaid in just over a year, it would make sense to launch a new operation to ensure banks don’t run out of cash. This, though, should only be done as part of a joined-up plan to ensure banks are properly capitalised.

A more dramatic instrument would be to initiate a programme of quantitative easing (QE). This would involve the ECB going into the market and buying up large quantities of government bonds, in the same way that the U.S. Federal Reserve and the Bank of England do.

Last year, the ECB promised to buy unlimited quantities of peripheral governments’ bonds in order to preserve the euro. But QE would be different. It would involve buying bonds issued by all governments, including Germany’s, and its aim would be to push euro-wide inflation up to its target.

There would be two other beneficial consequences: the euro would fall, boosting the zone’s competitiveness; and the anaemic growth rate would pick up. QE would be a departure for the ECB. But now’s the time to embrace it.


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