Which way for the ECB?

Ahead of the ECB meeting, the debate on the right course for euro area macroeconomic policies has re-emerged. An interesting new feature of the debate is about differentiating monetary policy to better cater for different conditions in different countries of the euro area. So should there be more differentiation of monetary policy across countries and how much can monetary policy achieve?

Monetary policy first and foremost needs to look at the euro area aggregate. Inflation as well as core inflation in the euro area in April is at 1.2% and the 2-year-ahead market based inflation forecasts are below 1.5%. The output gap of the euro area for 2013 as of the February forecast of the European Commission stands at almost 3% suggesting significant slack in the euro area economy. The area wide economic indicators therefore clearly signal that the euro area is in a recession and that inflation is well below the envisaged 2%. For the area as a whole, more expansionary macroeconomic policies thus seem warranted.

Turning next to the individual countries of the euro area, the weak economy in the South of Europe is particularly worrisome. Yet, even the strongest countries of the euro area including Germany currently record a negative output gap. Inflation in Germany is below 2% at 1.8% in March and therefore almost at March euro area average of 1.7. So in absolute levels, Germany also appears to enter a recession and the low inflation rate would warrant a further stimulus to the German economy.

The snapshot of the current situation in Germany underestimates the need of Germany to be the growth locomotive of Europe. In the first 9 years of monetary union, euro area economic growth was driven by strong but unsustainable growth in the South. It is now for Germany to grow above average to help correct imbalances. German inflation rate had been significantly below euro area average while in several countries in the South of Europe it had been significantly above the average. This relative price divergence may require a correction of prices amounting to 10-20% depending on the countries considered. An arithmetic consequence of this past divergence is that going forward German inflation rates will have to be above the euro area average. For this to happen, the German economy should be in a strong boom.

Would a further rate cut by the ECB help to increase growth and investment in Germany? German banks can currently borrow at a rate that is significantly below the ECB repo rate. A cut in the main rate is therefore unlikely to ease funding conditions for German banks. The German ECB Board member Jörg Asmussen has therefore warned not to overestimate the effects of a rate cut. Instead, an increase in public investment would be warranted as a way to trigger growth. With German government bond rates at close to zero, any public investment project with a return higher than zero would be beneficial to the German economy.

An ECB rate cut would help banks in the South by lowering their funding conditions. Yet, a cut is unlikely to make a significant contribution to overcoming the deep recession in the South of Europe. The weak balance sheets of banks and the risk of zombification prevent proper transmission of monetary policy signals to the real economy. Funding conditions for corporations remain highly restrictive even when they have profitable business projects. In addition to a rate cut, the ECB should therefore step up its non-standard measures to promote credit growth, in particular in the South of Europe. This could include loosening collateral standards for corporate credits.

Overall, a rate cut is an important signal to guide market expectations but it is unlikely to make a big contribution to overcoming the recession. Instead, more aggressive measures to repair monetary policy transmission in the South of Europe and public investment in the core of the eurozone are warranted.