The ECB should be more aggressive on monetary policy

The case for more aggressive action is strong. Inflation in the euro area has been steadily falling since the end of 2011 and now stands at 0.7%, well below the European Central Bank’s target of below but close to two percent. The consensus inflation forecast estimates a 1.1% rate for 2014, while market-based indicators suggest that inflation will remain below 1.4% at a five year horizon. Clearly, the euro area has been experiencing major disinflationary tendencies. The ECB’s bank stress tests and asset quality review could lead banks to further curb lending and also global risk and a euro appreciation could undermine the recovery. In combination, deflationary risks are significant while the risk of overshooting the target is minimal. Yet, debt sustainability in many European countries will look illusionary with low and falling inflation rates. Unsustainable debt would then certainly trigger the next crisis. So what could be done?

The starting point should be more aggressive standard monetary policy. The ECB was slow to cut its main rate last year. The public debate in Germany – that low rates reduce the return on German savings – should not influence the ECB’s decision-making. Monetary policy by its very nature has distributional consequences. The ECB’s legitimacy depends solely on fulfilling its mandate, which requires it to contribute to the goals of the European Union, including increased economic and social cohesion, when its price stability mandate is fulfilled. The current disinflation certainly undermines cohesion as it undermines the sustainability of periphery debt. A further reduction in the rate combined with another long-term refinancing operation would be natural and fully within the mandate.

Second, the ECB should take measures to improve directly the credit flow to corporations and households, which is still impaired in the euro-area periphery. Certainly, part of the financial fragmentation is a consequence of the unfinished business of bank balance sheet repair and should be addressed in the asset quality review, the stress test and the subsequent bank restructuring. However, monetary policy should be used to increase the credit flow and avert the risk of deflation. The experience of the last Long-term refinancing operations round (LTRO) was mixed because a lot of the additional liquidity went into the purchase of government bonds instead of credit to firms. The ECB should therefore clearly communicate that it will penalise government bonds in the asset quality review, thereby pushing lending to the real economy. A lowering of collateral standards for credit to firms would be a further instrument.

Third and most controversial would be asset purchases. The purchase of corporate bonds and loan portfolios sold by banks would be relatively uncontroversial and would improve credit conditions in the euro-area periphery. Ending the sterilization of past government bond purchases would also be uncontroversial and push liquidity into the market. More controversial would be the buying of a portfolio of government bonds. It should reduce the spreads between the euro-area periphery and the core but its overall effectiveness is questionable and it will not increase growth and inflation in the core of the euro area by much. Funding conditions for corporations in Germany and France are already very favourable and German corporations in particular rely on abundant internal finance for their investments. For the periphery, however, the Outright Monetary Transactions (OMT) programme appears more appropriate as a last recourse measure, which requires a debt-solvency assessment and conditionality.

Overall, more monetary action is clearly advisable and would not require the ECB to go beyond its mandate. In particular, the euro-area periphery would benefit from another LTRO and credit-easing measures. The euro-area core, in particular Germany, needs supply-side reforms, measures to reduce the tax burden on the middle class and increased public investment in order to re-invigorate growth and increase inflation. Monetary policy needs to do more but further government action is also needed.