The European Central Bank has consistently failed to meet its inflation target in the seven years since the region’s sovereign debt crisis. Nor has the market any faith that it might do so in future.
With the European Union (EU) elections out of the way, the horse-trading over a host of top EU jobs will ratchet up. This includes finding a replacement for Mario Draghi as President of the European Central Bank (ECB). By the time the European Council meets on 20-21 June, a successor to Mr Draghi should become clear.
Whatever you think of Mr Draghi’s tenure, the ECB has a credibility problem that requires urgent attention. The ECB has consistently failed to meet its inflation target in the seven years since the European sovereign debt crisis. Nor has the market any faith that it might do so in future.
Persistently missing the inflation target has a genuine economic cost.
Persistently missing the inflation target has a genuine economic cost. It reduces the room to lower real interest rates and thereby add stimulus in a future downturn.
Worse still, the situation has become self-perpetuating. Low inflation has become so entrenched that financial markets doubt the ECB will reach its inflation target even 10 years from now. In fact, current market pricing implies that average Eurozone inflation in five-to-10 years’ time will be just 1.3%, well-short of the ECB’s 2% target.
What to do
A core aim of the new ECB president should be to get the Bank back on the right track. This could be achieved by, first, amending forward guidance to completely remove any prospect of a rate hike in 2020 and, second, by restarting the quantitative easing (QE) support programme.
Neither action would solve the Eurozone’s problems (investors have long concluded that a rate hike in 2020 won’t happen), but they would be a decent start in restoring the ECB’s credibility.
A bolder immediate step would be to slash the interest rate at which the ECB lends to banks under its TLTRO (targeted longer-term refinancing operations) programme. This would have the effect of ‘supercharging’ bank lending, thereby potentially stimulating economic growth.
The idea would be to set the interest rate at which banks can borrow from the ECB below the rate they get on funds deposited at the ECB. This would mean the ECB technically making a loss in the process. But this concept is meaningless for a central bank that prints its own currency. And it’s a policy tool that already exists.
Even more fundamentally, Mr Draghi’s successor should announce a review of the ECB’s entire monetary policy framework and inflation target. The current, vague formulation of “below but close to 2%” is just plain unhelpful. No one knows precisely what it means, which undermines its credibility from the outset. A new target of 2% core inflation would be more appropriate. Keep it clear and simple.
The ECB could go further, moving the inflation target to a ‘levels’ target. Under the current system, whenever the ECB has missed its inflation target in the past, there were minimal consequences for its future monetary policy. The advantage of a levels target is that any previous ‘misses’ of the inflation target have to be met with subsequent overshoots. This keeps the price level on an upward path over time. Ultimately, this approach offers more scope to cut interest rates when the economy requires stimulus.
The new president could go further still and expand the Bank’s monetary policy toolkit to include ‘yield-curve control’, similar to that used by the Bank of Japan. Essentially, it’s a way of keeping interest rates at a desired level. It could be achieved by anchoring all Eurozone government bond yields at the same level. Immediately, this would lower borrowing costs across most of the currency area and stimulate economic activity. This seems a radical proposal. But it’s simply the logical conclusion of saying there is zero default risk for Eurozone governments because, after all, the ECB has pledged to never let the Eurozone break up.
This would be a highly technical element of any solution. It would be hard to achieve and would probably be challenged in court. Also, it would be so politically divisive that it’s hard to imagine the ECB even trying to champion it.
And this is the rub for the ECB. The divisions among EU member states prevent them from doing what best serves their interests. Inventive monetary policy is all well and good, but it is only ever going to be part of the solution.
Above all else, Europe needs structural reform and counter-cyclical fiscal policy. Mr Draghi has been relentless in advocating such reforms but has never managed to stir the politicians into sustained action.
If Mr Draghi’s successor wants to restore the ECB’s credibility on inflation, and ultimately put the Eurozone on a sustainable course, then his or her Holy Grail must be to persuade Europe’s politicians to step up to the plate.
The above article was previously published by Aberdeen Standard Investments on 6th June 2019