What surprised me last week was not the European Central Bank’s decision to cut interest rates, but that so few people had expected it. That is astonishing since the ECB is certain to fall short of its inflation target – achieving an annual rate of close to 2 per cent in the medium term. Mario Draghi, president of the ECB, himself admitted as much last week that the central bank will only meet its target in the “medium to long term”. The big problem for him is not the reported fall in the annual headline rate of 0.7 per cent in October; this rate jumps about. It is the fall in core inflation, the rate excluding volatile items, to 0.8 per cent.
The ECB’s monetary policy decisions raise a number of questions. Will lower interest rates work? Will they help end the crisis? Can the ECB do all the heavy lifting alone? And how serious is the deflation threat anyway?
The answer to the first two questions is yes, it will work; and no, it will not end the crisis. Debt resolution remains necessary. Economic policies will need to change. But this does not imply that monetary policy is ineffective – not even now when interest rates are close to zero.
A simple rate cut would probably not have much effect since overnight market interest rates were already at zero. For that rate to fall, the ECB would have needed to cut the deposit rate – the rate that applies to bank deposits held at the ECB. But the ECB left that rate alone. Instead, the institution took two decisions – a cut in the official lending rate and the extension of unlimited liquidity until July 2015. The combination is effective because, together, the measures constitute an effective cap on interest rates for the next two years. The ECB has not just cut a rate, but is keeping down the short end of the yield curve.
This is what Draghi means when he talks about forward guidance. I do not like this expression because, to me, forward guidance implies a commitment to keep rates lower for longer than warranted. That is not the case here. But it still constitutes a forward-looking decision. The fastest real-world impact will come through the exchange rate. A slower – but still important – transmission channel runs through the banks. The extension of unlimited liquidity until 2015 gives them time to clean up their balance sheets, and this may eventually help them to increase their lending to the private sector.
The second question is whether this looming deflation is a purely monetary phenomenon or whether there is something deeper at work. Milton Friedman said that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. Logically, the reverse statement applies to deflation.
Is the eurozone different? I do not think so. The ECB has all the tools it needs to fight deflation – even in adverse circumstances. If Germany and the other creditor countries accepted debt write-offs in the periphery, or if they accepted that they, too, have to adjust – or that the banking union has to include some burden sharing – it would help. But even if none of this happens, and I do not think it is going to, monetary policy can still be effective – even in a dysfunctional monetary union. But the policies the ECB would need to deploy would have to become progressively more extreme.
The next tool in its arsenal is a negative deposit rate, another long-term financing operation, and quantitative easing in the form of purchases of sovereign and private debt. In theory, the ECB could even lend to companies directly, bypassing the banking sector. It cannot magically guarantee the survival of the eurozone. But it surely can prevent deflation. And finally, how should we think about deflation in a monetary union? A fall in Spanish consumer prices is not deflation, merely an intra-eurozone price adjustment. In a monetary union, the concept of deflation only makes sense at the aggregate level – a sustained fall in the eurozone’s price level. A core rate of inflation of 0.8 per cent is thus not deflation.
But it is unacceptably far from the inflation target of close to 2 per cent. There are a number of reasons why the inflation target is at 2 per cent and not at zero. Maintaining a positive real inflation rate makes the zero bound on interest rates into less of a problem. And a higher target rate means that a period of undershooting is less likely to tip an economy into a debt-deflation spiral.
I do not foresee a long period of negative inflation, but I see a long period of below-target inflation, together with very low economic growth. The levels of debt to gross domestic product will thus not come down fast enough. This will prompt eurozone member states to run large primary surpluses, which in turn will produce even lower growth, and put even more pressure on prices.
The eurozone does not need outright deflation to get into trouble. Persistently low inflation rates will be sufficient to trap the eurozone in a vicious circle. This is why the ECB simply had to act.
Copyright The Financial Times Limited 2013.