The European Central Bank kept rates unchanged at 0.25 per cent at its January meeting but it will have to do more to support the fragile economic recovery and reduce the fears of deflation.
The ECB has employed more aggressive language at recent meetings and ECB President Mario Draghi certainly appears more proactive than his predecessor in his public statements. In November the ECB shocked most market participants when it cut interest rates further.
Yet despite the tough talk the ECB continues to drag its feet, focusing too much on the long-term outlook when most states in the region continue to suffer incredible economic pain. Make no mistake, this meeting was another missed opportunity by the ECB to provide additional relief to a region that desperately needs it.
The ECB downplayed the importance of disinflation with Draghi saying the bank is ready to take further action to prevent excessively low inflation from derailing the eurozone’s fragile economic recovery.
“We don’t see deflation,” Draghi said. “We are not in a Japanese situation.”
But they are in a Japanese situation and have been for some time. Not with regards to deflation perhaps but certainly with regards to a lost decade of economic growth. For many countries in the region it will be longer than a lost decade. The time for action isn’t next month but right now.
The focus on deflation is also misleading and unnecessary. Low inflation can be damaging in its own right, and continues to be, within the eurozone. Disinflation effectively acts as a form of monetary tightening by increasing the real interest rate that firms, households and governments borrow at. The real interest rate in the eurozone has increased by over 50 basis points since July 2013.
The eurozone would benefit a great deal from higher inflation – particularly in Germany – and the ECB target for inflation should actually be higher than 2 per cent to provide further relief. This is the problem with having a low inflation target; it actually limits how low real interest rates can go.
Perhaps I am being a bit unfair on the ECB but in an environment where most eurozone governments cannot do more to support their economies (such as Spain and Greece) or are simply unwilling to help (Germany), it falls to the ECB to do whatever it takes.
Generating more inflation is an important part of doing whatever it takes.
With few policy options, countries in the eurozone are relying on internal devaluations – changing relative wages via differences in inflation rates between eurozone countries – to increase competitiveness within the eurozone and against non-eurozone countries.
For a country such as Australia a freely floating currency does that job for us but that is not an option within the eurozone. The euro is too low for the likes of Germany and much too high for the likes of Spain.
Disinflation slows the internal devaluation and prolongs the economic damage and human misery resulting from this crisis. Not to mention greater inflation reduces the extensive debt burdens in a number of member states. More needs to be done and it needs to done now.
The ECB needs to expand its Long-Term Refinancing Operations to provide greater liquidity to the banking system and increase the willingness of banks to lend to households and businesses. Credit growth is anaemic in the eurozone and money supply growth is much lower than desirable given the current predicament.
It also needs to be more active in admonishing governments within the region that are able to provide more support for their economies but have failed to do so – particularly as bond markets improve allowing governments to use fiscal policy to support their economies.
The ECB must recognise that a solid industrial production number or improvement in consumer sentiment doesn’t mean a great deal when the unemployment rate is at 12 per cent, the population is ageing and most governments in the region are unable to help.
Hopefully improving bond markets will reduce the need for the ECB to do all the heavy lifting but for now that’s all we have. Tough talk is welcome but now is the time for action and the ECB missed another opportunity last night.