He gave the markets what they wanted but did the markets want enough? Mario Draghi has already succeeded in rescuing the euro from imminent collapse by promising to do “whatever it takes”. Will the latest set of monetary measures be enough, however, to rescue the eurozone from imminent deflation?
Thursday’s announcements, while welcome, suggest the European Central Bank may not yet be fully engaged with the fight against the possibility of falling prices. Long-term refinancing operations (LTROs) were first introduced in 2008 and extended considerably in 2011. They’ve now been extended again, with a particular emphasis on kick-starting lending to companies. So far, however, LTROs have done nothing to prevent a seemingly relentless deflationary process. More of the same doesn’t sound like a recipe for success.
Cutting interest rates was a no-brainer – and the (possibly ineffective) introduction of a negative deposit rate was widely expected – but, as Mr Draghi indicated, the ECB has, to all intents and purposes, now reached the zero rate bound. Purchases of asset-backed securities remain in the planning stages while the really big bazooka – outright purchases of government bonds through quantitative easing – is still waiting in the wings.
Mr Draghi is relying on his reputation as the man who will “do whatever it takes” to lift market sentiment. There is a risky Wizard of Oz quality to this approach. It works so long as we believe it works. If we stop believing, it fails. The acid test will not be Toto the dog but, instead, the path for inflation in coming months. The ECB has revised down its inflation forecast for the next three years but is still persuaded that inflation will rise from current rates to an average of 1.4 per cent in 2016. That’s not exactly high. It is, however, a lot higher than the current 0.5 per cent rate. If, instead, inflation continues to fall, the ECB will be in trouble.
That possibility cannot be ruled out. After all, the ECB’s recent forecasting record has not been particularly wonderful, partly as a consequence of a stronger than expected currency (itself a result of Mr Draghi’s earlier “whatever it takes” commitment). So one test of success lies with the performance of the euro in coming months.
First signs were encouraging, to the extent that the euro initially dropped sharply following Thursday’s announcements (although it ended up on the day in Europe). We already know from the UK experience in 2008/09 and Japan’s in 2012/13 that the expectation of imminent quantitative easing can drive the currency lower, push up import prices and trigger an increase in headline inflation. Mr Draghi will presumably be hoping that the hint of more actions to come will be enough to drive down the euro, setting in train a similar process.
While the approach has its attractions, there are also considerable risks. A big drop in the euro may only serve to export the eurozone’s deflation to other parts of the world in a monetary version of “beggar-thy-neighbour”. While higher import prices may lead to higher headline inflation, there is no guarantee that growth will pick up: both the UK and Japan discovered that higher inflation simply eroded real household incomes. And even early enthusiasts for quantitative easing (the US and UK) have more recently ended up with much lower-than-expected rates of inflation. In a world where companies, households and governments are engaged in deleveraging, and where banks are in some cases short of capital, monetary policy – conventional or otherwise – has its limits.
Stating that deflation will be avoided is one thing, making sure it will be avoided is another thing altogether. It’s too easy to forget that, in the mid-1990s, most economists thought Japan was about to embark on a modest but sustained economic recovery consistent with growth of around 3 per cent per year and inflation at around 2 per cent. They were totally wrong. They failed to understand that, at the zero rate bound, persistent declines in inflation have costly economic consequences: higher real interest rates, higher real debt levels, more aggressive deleveraging and more and more non-performing loans. Under those circumstances, the credit system freezes, bond yields drop and the economy stagnates. Conditions in the Eurozone are eerily similar. As with 1990s Japan, deflation remains a big risk partly because no one is prepared to admit it could really happen.