A New ECB Outlook? Part I
The European Central Bank (ECB) seems to be tiptoeing toward further easing of monetary policy in the euro area. Inflation has dropped to just 0.5 percent in March and the pressure for action is increasing. During the biannual financial meetings in Washington, the International Monetary Fund (IMF) reiterated its earlier recommendation that the ECB do more to counter excessively low inflation in the euro area. In a sign of its attitudinal change, Mario Draghi, the ECB president—who had previously thanked the IMF sarcastically for being "extremely generous in its suggestions on what we should do or not do"—signaled the central bank's intent to ease monetary policy if the euro exchange rate appreciates further. In addition, an ECB executive board member, Benoît Cœuré, discussed possible asset purchases in a speech.
In this posting, I discuss short-term options before the ECB. In Part II, I will analyze possible paths of ECB action in the second half of 2014.
Several factors are likely to guide the ECB in coming months. First, its 3-year macroeconomic projection in March estimated a gradual rise in euro area inflation toward 1.7 percent at the end of 2016. Any change in policy would have to be based on forecast deviation from that path.1 A rebound in euro area inflation in April (from 0.5 percent in March) is expected because of the lateness of the Easter holiday this year. Thus a change in ECB policy before the June meeting of the Governing Council is implausible.
If inflation rises in April and May, the ECB can avoid additional measures to ease monetary policy and its use of mere oral intervention—such as expressing "unanimous support for future non-standard measures—if required"—will have been vindicated.
But if the new data show a lower trajectory for inflation, the Governing Council faces a renewed debate on what to do next. Massive changes to the forecast are unlikely, however. The ECB's inflation forecasts have been path-dependent, with only minor revisions every three months. Forecast euro area inflation for 2014 has come down from 1.3 percent in 2013 to 1.0 percent now, and for 2015, from 1.5 percent earlier to 1.3 percent now.
Draghi's recent mention of the euro exchange rate as an important element in the inflationary outlook means that potential new policy action in June would probably take the form of a further cut in the main interest rate from 0.25 percent toward zero, reducing the ECB deposit rate to negative territory. It is unclear if a further appreciation of the euro before June (against the US dollar or in trade-weighted terms) from rates last week would be required for such an action. But any further euro appreciation would increase the probability. Unchanged euro exchange rates combined with a downward revision of forecast inflation may not sway the Governing Council.
Initially, any reduction of the deposit rate to negative territory would likely be small, –0.1 percent or –0.2 percent at most. Such a reduction would be in line with earlier incremental moves by other non–euro area central banks in Europe. The ECB Governing Council may accompany such a move with a statement of willingness to cut deposit rates deeper depending on the foreign exchange market and banking sector response. But a cut into negative territory might have a larger psychological impact by showing that the ECB would be willing to take actions that until recently no one thought it would consider. Such an action should amplify the belief in the ECB's willingness to do "whatever it takes" to avoid deflation and thus help anchor longer-term inflation expectations in markets and the public.
As always in Europe, the broader political circumstances are also a factor. The French and Italian governments' recent U-turns on fiscal policy—they now say they will adhere to their national fiscal targets after all—have strengthened the overall case for pushing the ECB toward an easier monetary policy, one that might implicitly target the euro exchange rate.
Finally, the crisis in Ukraine presents a wild card. Were it to escalate into armed conflict or sweeping sanctions against Russia, a negative shock would be felt in the euro area economy, focused on the Eastern members and those heavily dependent on energy imports from Russia. A preemptive easing action by the ECB, including nonstandard measures, would become more likely.