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The ECB’s dilemma

We ask if the policy choices left in the ECB’s armoury to tackle inflation and low growth are just blunt weapons.

On 28 April, the Spanish electorate will go to the polls for the third time in three-and-a half years. Both left and right of the political spectrum have upstart, extreme parties nipping at their heels. 

However, the measures taken to reinforce the economy after the global financial crisis have left a legacy of strong growth, unlikely to be disrupted by an election which will probably produce a centre-led coalition. There are similar success stories in Ireland and Portugal. 

The same cannot be said of Europe as a whole. Despite more ‘normal’ levels of political risks, Europe is faced with dangerously low inflation expectations. More recent economic weakness raises questions as to which measures the ECB could deploy to raise inflation sustainably back to target.

In the US, where the Fed has been raising interest rates, and the UK, which has opportunistically hiked rates, there is some room to ease monetary policy if required – or at least pause. However, unlike the US Federal Reserve (the ‘Fed’) and the Bank of England’s Monetary Policy Committee, the ECB is committed to certain strictures which mean that its hands are tied. In terms of monetary policy, the ECB cannot buy government bonds at the same rate as the Fed and Bank of England were able to – it has a limit on purchasing any new issue of 33%.

This is because if there is a restructuring of government bonds, the bank does not want to be at risk of making a potentially political decision. So last year, the ECB reached a limit, tapering its quantitative easing programme. And even if data continues to disappoint in Europe, the ECB may be unwilling to reduce interest rates further due to the uncertain impact of negative rates. 

On the fiscal side, various policy tools such as Modern Monetary Theory (MMT) have emerged. An environment of low growth and low inflation, its proponents argue, means that the traditional concerns about government borrowing do not apply. They advocate for ramping up debt to spend on infrastructure projects and printing money to pay interest.

However, the ECB has been reluctant to sanction this kind of intervention. In order for MMT to work, the ECB rather than any Eurozone government would have to print euros. Any inflationary effects would not be contained to a single economy, but would have continent-wide ramifications. And how would the money be distributed and to who? In an organisation which favours balanced budgets, some of the more powerful voices do not want to allow Italy and Spain to run structurally higher deficits. Other concerns, such as the power that policies like MMT would reassign to the political sphere against a backdrop of unease about interdependence between central banks and the state are nascent but may grow as such theories come to prominence.

So, what’s next?

Optimists hope that recent Chinese stimulus may lead to stronger growth globally, allowing the ECB to be patient before changing monetary policy. Also, the ECB has been keen to stress that its toolkit is not empty, and could deploy methods to boost the transmission mechanism of its current monetary policy programme. European banks have already signed up for long-term refinancing operations (LTRO), offering extremely cheap loans to banks for terms of around three years. Targeted long-term refinancing operations extended this term for a further four years, but with TLTRO I set to expire in June,  details of a further round of cheap loans will be announced in the ECB’s June meeting.

And ‘tiering’, which relieves banks from paying a 0.4% annual charge on some of their excess reserves, might put a spring back in the Eurozone economy’s step. This could further aid the transmission mechanism of monetary policy; allowing the ECB to maintain extremely low deposit rates and give banks some relief. Although some prominent voices, such as Benoit Coeure, ECB board member, and Governing Council member Klaas Knot, who is potentially in the line-up to succeed President Mario Draghi, have denied that there is currently a clear case for tiering, we think this could be one to watch…