Now that the European Union parliamentary elections are out of the way, the question for the European Central Bank is will it or won’t it?
The eurozone has experienced a mild recovery in the past six months, but unemployment remains at record highs and the so-called output gap between potential and actual remains big. Moreover, the dreaded vista of outright deflation remains just around the corner.
So the quandary remains for the ECB: will it finally launch a programme of quantitative easing to combat the risk of deflation and support the financial sector as it faces a more severe round of stress tests and capital raising?
What is needed is a persistently weaker euro. To get to that, the ECB needs either to embark on a comprehensive QE programme or intervene in the foreign exchange market.
The exchange rate is not an official policy target but euro appreciation is a matter of great concern that must be addressed. And the ECB council is unanimous in being ready to use ‘extraordinary measures’ to combat a prolonged period of low inflation (not just deflation).
The eurozone has a current account surplus of 2.9% of GDP and capital is also flowing in from geopolitically unstable areas such as Russia (which ECB president Mario Draghi estimates has seen €160 billion – 10% of GDP – of capital flight this year) to buy peripheral bonds.
Normally the banking sector could be counted on to recycle all or part of this surplus abroad. But because eurozone banks are deleveraging — particularly out of foreign assets — this is not happening.
Second dilemma
The resultant strong exchange rate feeds into the ECB’s second dilemma; persistently low inflation that makes nominal GDP growth in peripheral economies too low to achieve debt sustainability, or make their economies competitive without cutting nominal incomes.
The only way to address both issues is to expand the ECB balance sheet and boost the supply of euros. There has been a net shift of $1.75 billion in the difference between Federal Reserve and ECB balance sheets in the past year or so, driving up the euro.
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A negative deposit rate is really only a token measure and carries with it several pitfalls: it would be disruptive for money markets, which could feed through to increased financial market fragmentation; bank profitability would be compromised, particularly in the peripheral economies (for example, Ireland, Spain, Portugal and Greece); there would be very little effect on the “low inflation for a prolonged period issue”, which is a key policy target now and a big threat to peripheral debt sustainability; and any impact on the euro would be relatively short lived given growing market expectations for more significant action.
Long-term credits from the ECB (LTROs) can deal with the problem of monetary transmission and financial fragmentation, which Draghi said was getting better. But it is impossible to push loans onto banks which clearly don’t want them – evident in the sharp contraction of excess liquidity already seen at the ECB.
Only QE or FX intervention would address the strong currency/persistently low inflation problem. If Draghi does not deliver something along these lines the market will take the ECB on and push the euro towards $1.50. This would guarantee another leg lower in inflation, forcing the ECB to act from a worse position and at a greater cost.
Lowflation
Given that the ‘lowflation’ problem is long-standing, why the delay? The ECB has German agreement on QE. Plus the ECB’s balance sheet has shrunk 25%, which makes objecting to expansion more difficult. So the delay is either about getting the technical batteries into place for QE or to secure the (required) agreement of eurozone finance ministers to intervene on the currency.
Capping the euro would be new. But even the ECB has called the exchange rate unacceptably high and it would not say that unless it was saying it would do something about it.
Intervention might also sidestep some of the legal issues linked to QE. A QE programme would still be accompanied by the usual appeals to the German constitutional court by German eurosceptics, which could tarnish it. Currency intervention, on the other hand, is totally legal under EU laws and can’t be challenged.
In the end it really comes down to whether the euro is set to be weaker or not. I reckon it will be, even if the measures to get there can vary.