ECB caught up in economists’ spat

The European Central Bank has found itself caught in the crossfire of a battle raging between the world’s leading macroeconomists.

The Bank for International Settlements’ call last month for the world’s central bankers to hurry up and raise interest rates has reignited the debate over how to explain – and tackle – the financial and economic turmoil that has persisted over the past six years.

The debate is so fierce, the viewpoints so distinct, that two of the world’s leading multilateral organisations, the BIS and the International Monetary Fund, have completely different ideas on what the ECB’s next step should be.

In a blog post published today, the IMF reiterated its calls for the ECB to ease monetary policy further and embark on broad-based government bond buying, often referred to as quantitative easing, to defeat what its managing director, Christine Lagarde, has dubbed the “ogre” of a vicious bout of deflation.

The BIS is not calling for the ECB to raise rates tomorrow. No names are mentioned in the report, but it is clear its prescription is aimed more at the likes of the Bank of England, which is presiding over a much more entrenched recovery than that seen in the eurozone. The BIS does, however, believe the threat of falling prices is minimal.

The IMF post, styled as a simple Q&A on whether the QE “juice is worth the squeeze”, appears to take aim as much at the Basel-based BIS as residents of Frankfurt’s Eurotower.
The BIS’s claim that markets are “euphoric” and out of sync with economic reality is directly challenged by the fund.

While risk-taking and credit growth may grow excessive, this is not an immediate risk, certainly not next to that of too low inflation. So far, credit is still contracting in the euro area (barely positive even in Germany) and there is no evidence of housing/asset bubbles (not even in Germany). If bubbles are blown, targeted macro-prudential measures, which need further development, can be deployed.

Which side is the ECB on?

Mario Draghi has attacked the IMF over its constant calls for QE. But most top ECB officials, and indeed most senior central bankers, are intellectually closer to the fund than the BIS.

Like the fund, the ECB’s faith in QE is driven by a belief that large-scale government bond-buying can spur demand, which so-called “real economic indicators”, such as inflation and unemployment, show remains weak. In contrast, the BIS’s belief that monetary policy is too loose is based on what is known in economists’ parlance as a “balance sheet” view of the economy, which places much more emphasis on the financial cycle. (For more on the root of the intellectual differences, read this excellent post by Gavyn Davies).

At 0.5 per cent, inflation is worryingly low at just over a quarter of the target of below but close to 2 per cent. ECB president Mario Draghi has given every indication that officials would plump for QE if signs emerged that it would remain too low for “too prolonged a period”.

We have little idea of what that means in practice, however. And top officials have indicated they want to wait until the end of the year to judge whether the package of exceptional measures unveiled in June are enough to ward off any threat of a self-reinforcing bout of falling prices, which would cripple economies in the periphery by raising debt burdens and weakening demand.

Like his counterpart at the Federal Reserve, Mario Draghi was quick to hit out at the BIS report, saying the ECB did not agree that loose monetary policy was doing more harm than good.

However, Mr Draghi’s response also suggested that he was a lot more worried about asset price bubbles. Here is what he said earlier this month:

We are at the same time quite sensitive to the formation, creation, to the presence, of potential financial stability risks. And there, we’ve taken a number of initiatives to address these risks, from the asset quality review to the stress test to the recapitalisation of banks that are taking place now, as we speak, ahead of the results of the AQR.

Even in our TLTROs operations, if you are careful, you see that we’ve excluded lending to real estate, for real estate purposes, and to sovereigns. We’ve introduced this treatment with prudential filters for sovereigns that is quite conservative in our comprehensive assessment. And I think I can go on for a while on these measures that we’ve taken.