A central banker’s nightmare is losing control of inflation expectations. Whereas decades ago the challenge facing major central banks was reining in overly high inflation expectations – a process that ushered in central banks’ independence and inflation targets – the European Central Bank’s (ECB) challenge today is reviving unduly low expectations up toward its stated aim of “inflation rates below, but close to, 2% over the medium term.” ECB president Mario Draghi took a step in addressing this challenge at the 25 July Governing Council meeting, promising the council will act with determination at its next meeting in September.
We expect ECB easing in September – but will it be effective?
Come the fall, the ECB will likely deliver yet another easing package that could effectively deplete its monetary policy toolbox: We anticipate another small cut of the deposit facility rate to −0.50%, exempting banks’ excess reserves from the tax imposed by negative interest rates, and restarting asset purchases, including raising its self-imposed 33% issue and issuer limits on sovereign debt holdings. And to reinforce forward guidance, the easing package might include an ultra-long refinancing operation at a fixed rate to entice corporations and households to take out bank loans.
Yet as the eurozone enters its sixth year of unconventional monetary policy, is this not all pushing on a string? And if the ECB uses up what remains of its policy flexibility in the coming months, what will be the consequences the next time a recession materialises?
One lesson from Japan is that secular forces beyond the control of monetary policy can hold down inflation for long periods of time and there is little monetary policy can do to change that. Evidence suggests aging societies grow more slowly and produce less inflation, while globalisation, technological advancements, and labour market reforms that increase wage flexibility limit the pass-through of cost pressures from producers to consumers. These conditions describe the eurozone today. Even if the European Treaty mandates the ECB to take action, the efficacy of its marginal actions seems to be diminishing.
Market and investment implications
Investors should be wary of chasing returns in this latter phase of a decade-long bull market in risk assets. ECB activism has helped support growth in employment and wages and fostered significant asset price inflation. Yet consumer price inflation has been mediocre at best. This combination might explain why investment, mergers, and acquisitions remain muted despite extraordinarily low borrowing costs. European corporations’ profit margins have been squeezed in this environment as higher wages have not translated into higher consumer prices.
If corporations were unable to pass on cost pressures during the upswing, they likely will not be able to do so when the downswing materialises, either. At that point, corporate profits will probably contract, which will tend to increase the probability of default, putting pressure on credit spreads.
Will eurozone leadership turn to fiscal policy solutions?
Some observers highlight the risk that ECB monetary policy will become subordinate to fiscal policy (Draghi mentioned “fiscal” no less than 22 times during July’s press conference): If the ECB were to use up its monetary policy tools, fiscal policy would have to do more to support growth, and the central bank’s role in that environment would be to support the issuance of government bonds by purchasing them in the market, similar to what has happened in Japan over the past decade. If we accept the premises that secular forces are restraining inflation, that the ECB’s policy flexibility is almost exhausted, and that further asset purchases may only jeopardise financial stability, is it unrealistic to consider that eurozone governments might one day negate the central bank’s independence and charge it with supporting an objective of full employment, effectively subordinating monetary policy to government-led fiscal policy?
While this Japan-reminiscent scenario appears closer, Europe is not there yet and the ECB’s independence is enshrined in a treaty that the EU Council has shown reluctance to modify. For the foreseeable future, we don’t believe Europe’s central bank will lose its independence.
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