Is it time for the ECB to do more?

March 31, 2014

From financial forecasters to the International Monetary Fund, calls for the European Central Bank to do more to support the euro zone recovery are growing louder.

With inflation well below the ECB’s 2 percent target ceiling and continuing to fall, 20 of 53 economists in a Reuters Poll conducted last week said the bank was wrong to leave policy unchanged at recent meetings and should do more when it meets on Thursday.

And the pressure on the ECB to do more has mounted after the preliminary inflation estimate for March was published on Monday. The data showed inflation cooling down further to 0.5 percent, its lowest since November 2009.

The IMF’s top European official expressed worry over low inflation and said there was more room for further ECB easing after the March preliminary inflation data released.

Policymakers don’t seem to be ready yet, despite inflation falling to new lows each month since October and outright declines in prices in a few peripheral economies.

Bundesbank President Jens Weidmann said on Saturday the euro zone was not in a deflationary cycle and that the ECB should not overreact to a slower inflation rate.

Over the past week, other ECB policymakers – including Governing Council members Jozef Makuch, Ignazio Visco and Erkki Liikanen – have acknowledged that low inflation is a risk, while stopping short of saying the bank should act. At the bank’s March meeting, Draghi said the economic recovery seemed to be on track and did not need any extra push.

Of course, with the refinancing and deposit rates already at record lows of 0.25 percent and zero respectively, the question is whether or not the ECB has any effective tools left.

A growing number of economists recommend the ECB haul every last tool out of the shed – cutting the refinancing and deposit rates further and buying sovereign bonds of individual member nations, or quantitative easing.

Unsterilising previous ECB bond purchases from the Securities and Markets Programme, something that many forecasters incorrectly predicted would happen at the March, would not be enough. At the March meeting, Draghi said that while unsterilising the previous SMP buys was still on the table, it’s unlikely to do much. The ECB bought around 175.5 billion euros worth of bonds under the now-dormant SMP but offset those purchases with an equal amount of sales.

To make matters worse, the euro has mostly gained since October and has continued to stay strong, hitting a 2-1/2-year high of $1.3967 earlier this month. A stronger euro could hurt the euro zone’s nascent recovery by making exports costlier, and, in turn, affect trade.

During a speech in Vienna three weeks ago, bank President Mario Draghi said the euro exchange rate was “becoming increasingly relevant” in the bank’s assessment of price stability.

Here is what some economists are saying about what the ECB should do.

Richard Barwell, senior economist at RBS wrote in a note to clients:

Despite another weak headline inflation print we think that a Council in ‘all or nothing’ mode on rates will settle on ‘nothing’ – with members of the Council taking solace from the core/erratic split in current inflation, the looming bounce in inflation and the reasonable data flow on activity.
However, there should be a genuine discussion about taking the deposit rate into negative territory – a fact which President Draghi can use to put a positive spin on the meeting in the press conference.

Ken Wattret, chief euro zone market economist at BNP Paribas:

They should be providing additional monetary accommodation to bring inflation back in line with their definition of price stability more quickly. And if they don’t provide additional policy accommodation to achieve their objective they may well end up with persistent low inflation.

What I think they should do is use their conventional policy ammunition immediately. So they should reduce the refinancing rate, take the deposit rates below zero and then subsequent to that, I think they should be buying assets in the sovereign debt markets, bringing down risk premia between markets and weakening the exchange rate.

Of ending the sterilisation of SMP buys, he said:

I think that would help but I think that makes a marginal difference. You need to be talking about policy options which have a more significant effect.

Jonathan Loynes, chief European economist at Capital Economics:

They should do everything at their disposal and ending the sterilisation of SMP might be part of that, but the much more  important part would be to undertake full-blown quantitative easing program.

Large-scale asset purchases, particularly if they have the effect of bringing down the euro exchange rate – which I happen to think is a serious problem for the euro zone as a whole but particularly the peripheral economies – that is likely to be the most effective course of action.

Loynes also suggested the ECB could cut deposit rates and try to alter inflation expectations by changing their 2 percent target.

His view on the SMP option was similar to Wattret’s:

The SMP purchases are not particularly big relative to the economic challenges still facing the euro zone or, indeed, relative to similar sorts of programs taken elsewhere. So the SMP is probably not going to be big enough on its own.

Lena Komileva at G+Economics, who does not agree with the ECB’s policy and says they should implement national credit support programmes said:

The ECB has been keen to rebalance the market’s understanding of its reaction function, away from expectations of further near-term action.

Yet policy officials have come to recognise that, by signalling that the bar to further policy easing is higher than the markets had expected, they are encouraging greater euro appreciation, which reinforces disinflationary pressures.

- With Ishaan Gera in Bangalore

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