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Mario Draghi, president of the European Central Bank (ECB), noted in his recent testimony before the Committee on Economic and Monetary Affairs of the European Parliament that "in exceptional circumstances, our [the ECB's] measures were exceptional." The question now is whether current circumstances are exceptional enough to warrant additional nonstandard ECB measures, or perhaps whether there is a consensus on the ECB Governing Council that this is the case.
Unlike in May 2010, late 2011, or mid-2012, when the ECB mobilized its balance sheet to restore financial stability in the euro area, no objective indicators unambiguously scream crisis today. Rather the issue now is whether low inflation rates risk a plunge into outright deflation,1 requiring new dramatic ECB measures to avoid that danger. Are low euro area inflation levels influenced by global trends? (OECD average inflation is just 1.7 percent and G-20 average inflation just 2.6 percent.) Or do they result from sound relative price adjustments in the crisis economies in the euro area? Is the low inflation a reflection of declining energy prices or an excessively tight monetary policy? All these issues have produced divergent views.
With headline inflation below 1 percent in recent months, a related concern is whether the ECB is adhering to its price stability mandate of "maintaining inflation rates below, but close to, 2 percent over the medium term." What is meant by "the medium term" and how much faith should be put in future inflation indicators has produced different views on the ECB Governing Council, which will probably not launch any new major changes at its next meeting on March 6.
That session will mark the first availability of the ECB's new 3-year economic forecast, though it is unlikely to be so different from previous forecasts as to create a crisis atmosphere forcing dramatic new ECB measures. Ultimately, only token gestures—like ending sterilization of the remaining €176 billion of government bonds purchased under the Securities Market Program (SMP)—seem possible and are aimed at illustrating that the ECB is still monitoring the situation vigilantly.2 Perhaps a doubling in the excess liquidity in the euro area banking system—the cash available beyond what banks need day-to-day—will help avoid new spikes in the Euro Overnight Index Average (EONIA). But with the benchmark interest rate below the ECB's 0.25 percent interest rates, it is not clear if this step would affect the real economy.
These factors, added up, make it likely that the ECB will remain on the sidelines and not inject the euro area with a new forceful monetary stimulus. Despite the ECB's rhetoric about being "ready to act"—which has the potential to fuel a peripheral bond rally with false expectations of massive quantitative easing steps—the ECB seems unlikely to do anything new, at least before the results of the asset quality review (AQR)/stress tests of the major banks are published in the fall of 2014.
This likely wait-and-see approach raises questions about the ECB's traditional monetary policy role versus its new role as banking regulator. On the one hand, the ECB adamantly maintains that it has a firm Chinese wall between the two functions. But the ECB's stated intention to combat banking fragmentation in the euro area through the stress tests violates the principle of that separation. The stress tests should re-open interbank credit markets to all banks that pass the tests. In waiting for the AQR, the ECB is in essence relying on a supervisory initiative—the AQR/stress test is in some ways the ultimate macroprudential measure—to fix its monetary policy headache related to fragmentation. In the same way, a successful AQR/stress test that largely removes fragmentation and drives peripheral interest rates down toward those of the core countries would amount to a substantial monetary policy stimulus for the periphery and is therefore inherently also a monetary policy event.
To the extent that deflationary pressures in the euro area periphery result from elevated borrowing rates for the nonfinancial and household sectors, the ECB's supervisory arm is obliged to fix these issues. And only if the AQR/stress test fails to achieve this result does a monetary policy remedy by the ECB seem likely.
Notes
1. The issue of whether a headline inflation rate of 0.8 percent is commensurate with a price stability mandate of "close to, but below 2 percent" boils down to a debate about what is meant by "the medium-term.
2. Ending sterilization of SMP purchases potentially poses a further political problem, in that doing so directly contradicts ECB statements made at the time of the launch of the SMP concerning the need to sterilize these purchases to avoid unintended economic consequences. This might raise concerns in some quarters—e.g. for instance the German Constitutional Court—that potential OMT or other large ECB asset purchases in the future might also at some point no longer be sterilized.
