Aberdeen Standard Investments Senior Economist Paul Diggle
With the EU elections out of the way, the horse trading over a host of top EU jobs, including who replaces Mario Draghi as President of the ECB, will ratchet up. By the European Council meeting on 20-21 June a successor to Mr Draghi should become clear. Whatever you think of Mr Draghi’s tenure, the ECB has a credibility problem that requires urgent attention. The ECB has consistently failed to meet its inflation target in the seven years since the debt crisis, and the market has no faith that it will do so in the future either.
Persistently missing the inflation target has a genuine economic cost. It reduces the room to lower real interest rates and add stimulus in a future downturn. Worse still, the situation has become self-perpetuating. Low inflation is so entrenched that financial markets don’t think that the ECB will reach its target as far out as ten years in the future. They currently calculate that average Eurozone inflation between five to ten years from now will be just 1.3%, a long way short of the ECB’s target.
The new ECB President should try to get the ECB back on the right track by, firstly, amending forward guidance to take a rate hike in 2020 off the table entirely; and secondly restarting the QE programme. Neither would solve the Eurozone’s problems (investors have long concluded that a rate hike in 2020 won’t happen) but they would be a decent start. A bolder immediate step would be to deeply cut the interest rate at which the ECB lends to banks under the TLTRO programme, supercharging bank lending. The interest rate could be set below the depo rate that banks receive on funds deposited at the ECB. This would mean the ECB paying banks to take loans from it at a higher rate than it is charging banks to hold deposits with it, technically making a loss in the process. But this concept is meaningless for a central bank that prints its own currency. And the beauty is that it is a policy tool that already exists.
Even more fundamentally, Mr Draghi’s successor should announce a review of the ECB’s entire monetary policy framework and inflation target. The current, vague formulation of “below but close to 2%” is just unhelpful. No one knows precisely what it means and that undermines its credibility from the outset. A new target should be set of 2% core inflation. Keep it simple and clear. The ECB could go further, moving the inflation target to a levels target. Under the current system, the ECB missing its target in the past has little consequence on its future policy. The advantage of a levels target is that previous misses of the inflation target have to be met with subsequent overshoots, to keep the price level on an upward path over time. Ultimately, this opens up more space to lower real interest rates when the economy requires stimulus. The new President could go further still and expand the bank’s monetary policy toolkit to include yield curve control, similar to the Bank of Japan. This could be achieved by committing to anchor all Eurozone government bond yields at the same level, immediately lowering borrowing costs across most of the currency area and stimulating economic activity. This seemingly radical proposal is simply the logical conclusion of saying there is zero default risk for Eurozone sovereigns because, after all, the ECB has pledged to never let the Eurozone break up. This would be a highly technical element of any solution that would be hard to achieve and would probably get challenged in court. It would also be so politically divisive that it is hard to imagine the ECB even trying to champion it. And this is the rub for the ECB. The divisions amongst Europeans prevent them from doing what is most in their interest. Inventive monetary policy is all very well and good but it is only ever going to be part of the solution.
Structural reform and counter-cyclical fiscal policy is what Europe needs above all else. Mr Draghi has been relentless in advocating this but has never managed to stir the politicians into sustained action. If his successor wants to restore the central bank’s credibility on inflation, and ultimately put the Eurozone on a sustainable course, then their Holy Grail will be to get Europe’s politicians to step up to the plate.