ECB Preview: Credibly Promising to Behave Irresponsibly

ECB Preview: Credibly Promising to Behave Irresponsibly
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ECB Preview: Credibly Promising to Behave Irresponsibly

The eurozone’s economic problem is too little inflation. Inflation has undershot the European Central Bank’s (ECB) target of 2% since 2013, and the ECB staff’s current inflation forecast of 1.7% for 2017 looks unrealistic. Without additional measures from the central bank, we think inflation in 2017 could be as low as 1.3%. Five years of below-target inflation (2013–2017) runs the risk inflation expectations permanently de-anchor – as witnessed in Japan – from the target. Additional stimulus, we believe, is therefore warranted.

Economic agents (market participants, decision makers) change their expectations in response to shocks. The risk, from a policy perspective, of a tepid (less shocking) ECB response is that it becomes the “new normal”, i.e., agents learn to believe the new policy is permanent without changing expectations. It is arguably more effective therefore to act quickly with force rather than drag out the policy response.

With this in mind, our baseline for the ECB’s Governing Council meeting on 3 December is that it will endeavor to shock inflation expectations upward by credibly promising to behave irresponsibly. Doing so will entail both increasing the quantity of asset purchases and cutting interest rates.

We think the Council will increase monthly asset purchases from the current €60 billion to about €70 billion, effective January 2016, and extend this pace to at least March 2017. The ECB’s expanded quantitative easing (QE) programme, which will probably be dubbed QE2, could end up adding an additional €500 billion of asset purchases on top of the original €1.14 trillion the ECB already intends to purchase. Together, this will amount to about 15% of eurozone GDP. Adding bonds from local governments and their agencies will facilitate achieving QE2.

In addition, the ECB will likely lower interest rates on the standing facilities. We think the Council will cut the Main Refinancing Operations rate by five basis points (bps) to 0% and the Deposit Facility rate by 10 bps to -0.3%.

We see the risks to this forecast to be even more, rather than less, stimulus.

One possible risk to the broader economy of more stimulus is financial instability. High levels of monetary and funding liquidity provided by the ECB potentially beget a feedback loop that lowers market and asset price liquidity. This poses a dilemma as asset prices in the eurozone are already influenced by the ECB. But doing nothing is not an option. In our view, the ECB needs governments to enact and enforce fiscal and structural policies to complement its expansionary monetary policy. Without government contributing to growth, overreliance on monetary policy runs the risk of sowing the foundation of the next financial crisis. Yet, without more stimulus, the eurozone runs the risk of its challenges becoming more embedded, like they have in Japan.