It is time for the ECB to act, but more talk is needed too
The picturesque town of Sintra has its own microclimate. But the subtropical atmosphere in the hills above Lisbon, where most of the European Central Bank’s top officials gathered last week, was not quite rarefied enough to ignore events at ground zero.
The rise of the anti-establishment vote across Europe, disappointingly weak growth and too-low inflation weighed on the mood at the gathering of central bank governors and leading academics. Some of those present are now back in Frankfurt, where the rate-setters on the governing council this Thursday are expected to unveil measures to stop conditions from worsening.
The need to act now is clear. Mario Draghi warned last week of the threat of a pernicious negative spiral of low inflation and tight credit conditions, which would derail the bloc’s fledgling recovery and destroy the ECB’s credibility to target inflation of close to 2 per cent.
The risk is especially great in the bloc’s weaker members, where, the ECB president acknowledged, lending constraints on cash-strapped businesses threatened to lower inflation further. With inflation in many of these economies close to, or below, zero, a further bout of disinflationary pressures could force more troubled member states into a prolonged bout of Japanese-style deflation. In such circumstances, demand would completely collapse and debt burdens soar.
Crucially, it looks as though Mr Draghi has managed to secure unanimous support for an injection of cheap central bank cash targeted at boosting lending in the periphery. Though the debate on interest rates is more finely balanced, strong support from most of the governing council for cuts is likely.
But even strong hints from officials of a move into negative territory for interest rates, alongside lending support for the bloc’s smaller businesses, have not been enough to quell doubts that it is all too little, too late.
Economists at Goldman Sachs have argued that going boldly below the zero bound – a radical move that neither the US Federal Reserve nor the Bank of England has tried – would have been more effective 18 months ago. Then there was more excess liquidity sloshing around the eurozone’s banking system, all of which would have been subject to the levy that negative interest rates in effect impose.
Neither that, nor the cut to the main refinancing rate, are expected to have much of an impact on the bloc’s economy. There were also murmurings at Sintra that one part of the ECB’s strategy to ease lending constraints on smaller businesses would prove fruitless.
The ECB has long hoped the repackaging of bundles of loans into asset-backed securities would encourage lending to smaller businesses. But with the exception of Adam Posen, formerly of the BoE’s Monetary Policy Committee, the academics at the conference were largely critical of attempts to restart the market for securitisation.
Sir Paul Tucker, the BoE’s former deputy governor, now at Harvard, warned that the ECB’s backing of the market could amount to a fiscal transfer, with the bank left on the hook when things go wrong.
Stephen Cecchetti, an economist at Brandeis University, asked why, if repackaging small business loans was so easy, no one had thought of it before. Mr Cecchetti said that even before the financial crisis, when creators of asset-backed securities were at their most inventive, there was little market for packages backed by SME loans.
Privately, some at the central bank admit that demand is so weak that any real pick-up in lending is doubtful.
So what can the ECB do to counter scepticism?
After more than six months of nothing but jawboning, many have condemned the bank as all talk. Paradoxically, some now think what Mr Draghi has to say on the possibility of quantitative easing will be the most important aspect of this week’s meeting.
“Even a unanimous decision does not mean everyone will . . . be on board for further unconventional measures,” said Nick Matthews, an economist at Nomura. “What will be important for markets is the rhetoric and openness to further action. Where they stand in terms of commitment to doing more will have the most impact.”