Opinion

James Saft

Dwindling inflation puts pressure on ECB: James Saft

February 25, 2014

Feb 25 (Reuters) – Never a hot-bed of monetary policy
activism, the European Central Bank may soon find itself forced
into an uncomfortable period of experimentation.

At issue is inflation, or rather its increasing scarcity:
euro zone inflation fell at its fastest ever month-on-month pace
in January, down 1.1 percent from December. Only three small
countries, Estonia, Slovakia and Latvia, saw consumer prices
rise in the month, with the rest flat or in outright deflation.
Annual inflation came in at 0.8 percent, far below the ECB’s 2.0
percent target and slightly below economists’ expectations.

Indeed with Germany seeing a month-on-month decline in
prices, the supposed contrast between a healthy core and
sclerotic periphery is harder to see, at least in inflation
terms.

“The disinflation trend is broad-based across the euro zone.
All countries are contributing to lower inflation. It is not
just the internal devaluations of program countries that are
pushing euro zone inflation down,” Andrew Bosomworth of Pimco
wrote in a note to clients, referring to countries like Greece
and Ireland which are following programs of economic reform
which have wage, living standard and price compression as
unwanted side effects.

Just think what might happen to prices if France and Italy
were to some day actually launch the economic reforms they’ve
been threatening these many years.

So far ECB head Mario Draghi, using a narrower definition of
deflation, is sounding not exactly like a man ready to pull the
trigger on rate reductions or other extraordinary monetary
policy.

“We don’t have any evidence of people postponing their
expenditure plans with a view to buying the same thing at lower
prices, in other words we don’t see what is defined to be
deflation,” Draghi told reporters in Sydney on Sunday after a
meeting of the Group of 20 nations.

“We are aware of the risks. The Governing Council is willing
and ready to take any action in case these risks were to
gain strength.”

Early estimates of February inflation will be released on
Friday, setting the stage for the next ECB policy meeting on
March 6, at which time it will also publish longer-term
inflation forecasts for the first time. Financial markets show
investors see a 10-basis-point reduction of key ECB rates by
mid-year as about a 50-50 proposition.

Even so, if we have learned anything during the past six or
so years it is that the dominant central banks on either side of
the Atlantic make quite a contrast. Where the Federal Reserve is
impatient and quick to move, the ECB, while certainly innovative
in tough times, seems more inclined to taking the advantage of
time before deciding.

MOVING PIECES

All of which may leave us somewhat surprised if the ECB does
react strongly, in no small part because some of the measures it
may take will seem radical. One, paying, or charging, a negative
interest rate on short-term deposits it holds, would form an
incentive for banks to lend or hold riskier instruments, but is
unlikely in and of itself to make a huge difference.

Some, particularly the direct buying of bank loans from
banks, may also have some key advantages over QE as it has been
practiced in the U.S.

While the ECB would prefer to stay away from buying
government bonds, which many argue would violate its governing
treaty which prohibits monetary financing, the alternatives
present their own difficulties.

There simply isn’t a big enough and liquid enough
asset-backed and covered bond market to give scope for purchases
with enough oomph to be meaningful. And while European banks
have huge balance sheets full of loans, and good reason to want
to offload them and shore up capital, the ECB may not have the
expertise needed to negotiate, purchase and manage a huge loan
portfolio.

That said, buying loans could work quite well in a European
context. Europe is more dependent on bank financing, as opposed
to capital markets, than is the U.S., making loan purchases more
likely perhaps to stimulate the real economy, as opposed to
simply goosing prices in financial markets.

And while the red line of monetary policy in the U.S. is
“picking winners” within the economy, which such a program
arguably would do, in Europe the taboo is more about financing
governments.

Even if the ECB went for credit easing, as buying bank loans
can be called, it will have a hard time buying enough. With
money supply in the euro zone about 1.4 trillion euros short (by
Pimco estimates) of its pre-crisis trend, the ECB will need to
buy a whole heck of a lot of something to address the inflation
drought.

Innovative as it may become, to achieve that scale of
stimulus will be hard without buying government debt, taboo as
it may be.

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