Will the ECB's Easing Work?
The European Central Bank is poised for a big change: Its June 5 policy-making meeting will probably mark a formal and explicit shift toward using extraordinary measures -- broadly similar to what the U.S. Federal Reserve has already done -- in an effort not to fix dysfunctional markets but, instead, to raise an inflation rate that it deems has been too low for too long.
The question is whether it will work.
Now that the German Bundesbank has signaled its support, the ECB has strong political air cover for a variety of measures such as large-scale bond purchases and further interest-rate cuts, including to negative levels. Markets already expect something to happen: Short-term borrowing rates in euros have declined, and yields on 10-year German government bonds have fallen to 1.20 percentage point below those of their U.S. counterparts -- the largest spread since 2005.
ECB officials have gone through a remarkable mind-set change to reach this point. Unlike the Fed, the ECB has only one objective: inflation, a phenomenon to which its major shareholder, Germany, has an instinctive aversion rooted in the country's disastrous experience with hyperinflation between the two world wars.
The ECB's concern is that if inflation remains as low as it has for much longer, people and businesses will begin to expect it to stay that way or go even lower -- and those types of expectations tend to be self-fulfilling. Should this occur, and given the already low level of interest rates, economic growth would suffer and excessive debt burdens would become overwhelming. To make things worse, the euro's exchange rate could actually appreciate in the short run, adding to the pressures pushing down growth and inflation.
So will the ECB's policy shift end up as a short-term detour or a durable paradigm change? There are three issues to keep in mind in trying to answer this question.
First, don't underestimate the analytical challenges the ECB faces in ringing the "lowflation" alarm bell. The diagnosis assumes proper "look-through" -- that is, the ability to properly distinguish between a durable change in inflation and a temporary, reversible one. It assumes that the right measure of inflation is being considered, whether core or headline. It requires identifying the right target, be it a level of inflation, a certain path over time, a zone or a threshold. None of this is straightforward.
Second, the case for action rests on the ECB being able to durably alter the drivers of lowflation. This is certainly possible if they are cyclical in nature, related to the level of economic activity and, specifically, actual and perceived demand fluctuations. It is a lot more problematic if they are structural, related to problems of competitiveness and supply responsiveness more generally -- problems that only reforms of tax, labor or other policies can address. Virtually everyone agrees that the ECB is looking at a mix of both. The question is which matters a lot more at this stage.
Finally, the ECB's policy shift involves the threat of collateral damage and unintended consequences. It can encourage excessive risk-taking in financial markets. It harms savers, in terms of both the interest income they receive today and their ability to secure longer-term income for retirement. It can expose the institution to greater political meddling.
The ECB's signaling of an upcoming policy shift is best thought of as a tactical move aimed at minimizing the likelihood of really bad outcomes. Its strategic success will depend on a set of complex factors, some of which lie outside the influence of the central bank.
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