News Column

ECB's justified action will help but is no panacea for eurozone deflationary ills

June 6, 2014

Larry Elliott, theguardian.com



Mario Draghi has acted. He has won the whole of the European Central Bank's ruling council round to the idea that action needed to be taken to prevent the eurozone becoming the new Japan. Whether he has yet done enough to stop disinflation becoming outright deflation is another matter.

In truth, the ECB did as much as could have been expected at this meeting. It cut interest takes, taking the historic step of making commercial banks pay for lodging money at the ECB. And it came up with its version of the Bank of England's funding for lending scheme (FLS) with a targeted scheme that will reward banks that bump up their lending to private firms. This excludes lending to the real estate market, which shows that the ECB has learned some lessons from the FLS, which was a lot more successful at boosting mortgage lending than at providing funds for small- and medium-sized companies.

Was this action justified? There is no question that it was. Even the hawks on the ECB council led by Germany'sJens Weidmann are uncomfortable with an inflation rate of 0.5% and annual growth in the money supply of 1%. Inflation and the money supply are the twin pillars of ECB policy: both are running well below target.

Will the action help? Yes, but the impact is unlikely to be that dramatic. Interest rates in the eurozone were already close to rock bottom before the latest moves: cutting the deposit rate into negative territory is more a symbolic gesture than anything else. Nor is it obvious why the inducements to increase the flow of credit to the private sector – the targeted long-term refinancing operations – will be a magic bullet. It is not the lack of money that is deterring European banks from lending; many of them are awash with cash. Instead, the problem is that banks are keener on bolstering their balance sheets than they are on making loans. That coupled with a lack of demand has led to credit flows drying up.

Draghi believes that the offer of low interest rates over a four-year period will unlock bank lending. This looks questionable, which is why the ECB president was keen to point out that Frankfurt is stepping up its preparations for a full-scale quantitative easing programme. Powder is being kept dry just in case the eurozone edges closer to deflation over the coming months.

For some, this is a question of too little, too late. The time for QE is now, they argue, because the ECB is where no central bank likes to be: well behind the curve. Inflation is still expected to be below 2% by the end of 2016 even taking into account the measures just announced. The Federal Reserve and the Bank of England embraced QE more than five years ago, so in a sense the ECB is now paying the price for its conservatism.

But the ECB is not the Fed or the BoE. Its decision-making process is more cumbersome and Draghi, whatever his own views, has to live with that. Keeping QE in reserve keeps the Germans on board but is also designed to drive down the value of the euro, thereby pushing up inflation. If that were to happen, the need for QE would be lessened and financial markets will once again be hailing Draghi's skill and cunning. His record so far suggests he deserves to be cut some slack.


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Source: Guardian Web


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