This is perhaps one of the most shocking statistics about the eurozone: the last time core inflation was close to the official 2 per cent target was in May 2007, almost nine years ago. The core rate, which measures the underlying inflation trend, is telling us that the European Central Bank’s monetary policy has been off-track for a very long time. And lately, the rate has fallen again. Is there something the ECB can do when its governing council meets this Thursday?
I have three recommendations. One useful measure that would bring immediate benefits would be purchases of non-performing loans in the banking sector. It could be accompanied by policies to force cross-border bank mergers. This would detoxify and restructure the banking system in a swoop. The objective should be not to protect bank profits but to get banks to take on more risk.
This would then make it easier for the ECB to cut the deposit rate, which applies to bank reserves at the central bank. The deposit rate is now -0.3 per cent. Negative rates are tricky. If they fall too low, banks may find it cheaper to store their reserves in cash vaults. Some German banks are already preparing for this.
No one knows how far rates can go down until that moment comes but we are not at that limit now. A rate cut of up to 0.5 percentage points — taking the deposit rate to -0.8 per cent — would still keep us on the safe side of that limit because the cost of insuring large amounts of vault cash is expensive.
My second recommendation is about measures that should not be taken — policy gimmicks. These are decisions that get some people excited but will not lift the rate of inflation. For example, the ECB should not buy bank bonds, or indeed any other form of corporate bonds, or equity. The reason banks are not lending is not a lack of funding but the presence of too many toxic assets on their balance sheets. It would be much better to address this problem directly.
Another gimmick to avoid is so called two-tier interest rates. The basic idea is to split the deposit rate into two, with a lower rate applied to reserves above a certain threshold. If you exempt a certain part of the reserves from the negative rates, you provide some relief, but that also reduces the effect of the measure itself.
My third recommendation regards future policies. The ECB should hold an open debate about policy alternatives, starting with a realisation that quantitative easing has failed. The ECB acted late, and did not do enough. QE, the injection of liquidity through large-scale purchase of bonds, might have worked if it had been implemented in 2008. When it was introduced last year, it was too late. The purchasing volumes were puny compared with similar programmes in the US, the UK and Japan; the time given for the programme too little.
Perhaps the most important difference is the operating environment. The programmes in the US and the UK started when market interest rates were higher than today. The European programme came when rates were already low. Since one of the main objectives of QE is to lower rates, its marginal impact is thus much smaller.
So what are the policy alternatives the governing council should discuss? I have argued in favour of a ‘helicopter drop’, even before the recent deterioration in economic growth and the outlook.
A helicopter drop means that the ECB would print and distribute money to citizens directly. If it were to distribute, say, €3,000bn or about €10,000 per citizen over five years, that would take care of the inflation problem nicely. It would provide an immediate demand boost, and drive up investment as suppliers expanded their capacity to meet this extra demand. The policy would bypass governments and the financial sector. The financial markets would hate it. There is nothing in it for them. But who cares?
The ECB has not run out of ammunition but the number of effective policy tools is clearly finite. It should not dismiss them casually, or it might risk losing what little credibility it has left.
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