European Institute

Although pressure has been rising to address the perils of low inflation, the European Central Bank held rates steady (April 3) at its meeting, but its president, Mario Draghi, emphasized the bank stands united in taking steps, including unconventional ones that include asset purchases, to combat inflation.

After a “rich and ample” discussion, the governing council, Draghi said, was “unanimous in its commitment to also using unconventional instruments within its mandate to cope effectively with risks of a too-prolonged period of low inflation.” An expectation of higher inflation in April—that inflation would rise to the bank’s 2-percent target-- was one factor in the decision.

Beyond that Draghi provided no specifics, leaving a tidal wave of speculation by ECB watchers, who parsed Draghi’s words to opine over how open the ECB would be “quantitative easing,” what the trigger points will be, and what tools would be used given the bank’s mandate and the unknown risks.

“Draghi’s statement appeared slightly more dovish but without any commitment to deliver easing in the future,” said a foreign exchange strategist. “It is hard to say how much of the rhetoric is a genuine signaling of Q.E. intent and how much is just trying to talk down the euro,” said an asset manager.  

Deflation Worries Escalate as ECB Contemplates “QE” with Negative Interest Rates (4/1)

Faced with potential deflation that may undermine Europe’s modest growth, the European Central Bank has been signaling since November that more stimulus measures may come this spring, including “negative” interest rates to jumpstart bank lending. With the latest flash data showing price declines in Spain, inflation throughout Europe well below ECB targets, and peripheral countries’ debt rates falling, pressure is building on the ECB to take action when meeting Thursday (April 4).

For months, ECB officials feared Eurozone “disinflation,” a fall in the rate of inflation. That materialized over the winter. In January, consumer prices rose just 0.7 percent over the previous year with new lows (0.5 percent) in inflation estimates released Monday (March 31) by Eurostat. ECB’s target is two percent.

Government leaders, bankers, investors, and economists increasingly believe this disinflation is morphing into “deflation.” That’s a debilitating situation in which the values of real estate and other assets decline, the prices of goods and services drop, and wages slide. People become reluctant to spend, hoarding cash instead. Repaying loans becomes more costly in economic terms in contrast to when there’s inflation and loan repayments are less and less costly over time (inflation reduces the value of the money used for each payment). Borrowers may walk away from mortgages, for example, on houses that are worth less than the mortgage debt. Already fragile financial institutions become more vulnerable. Once underway, a deflationary cycle feeds on itself, ever-worsening in a downward spiral.

Deflation is already underway in Spain, where the consumer-price index slid 0.2%, Greece, where prices have been falling since last year, and Portugal, where prices fell last month, the first year-over-year decline since 2009. The International Monetary Fund warned in February: "A new risk stems from very low inflation in the euro area, where long-term inflation expectations might drift down, raising deflation risks in the event of a serious adverse shock to activity."

On Monday, Philippe Gudin de Vallerin, chief European economist at Barclays, was the latest to reiterate IMF’s concerns: “The risk of deflation is definitely mounting. The risk of de-anchoring inflation expectations is rising. The ECB can argue that it’s a base effect. But if you look at the trend since last summer, they’ve been revising inflation down and down.”

Source: Financial Times, March 31, 2014/

Reversing deflation means firing up inflation. That’s where negative interest rates are seen as a tool now that the ECB has more or less exhausted its room for conventional policies. Its two key interest rates, deposit and lending, stand at 0 and 0.25 percent, respectively. Last November, ECB President Mario Draghi said that the central bank is “technically ready” for a negative deposit rate if warranted. Two central bank heads, Germany’s Jens Weidmann and Finland’s Erkki Liikanen, and ECB executive board member Sabine Lautenschläger (Germany) have all mentioned negative deposit rates as options.

Negative interest rates have been used before by central banks but only rarely and with mixed results. “Central banks typically implement quantitative easing policies via large-scale asset purchases,” according to two Federal Reserve economists Richard G. Anderson and Yan Liu.^[1]

If the “nominal” rate (the stated rate) is negative, the central bank in effect is taxing banks (in this case forcing banks to pay to the ECB to deposit funds there), or the banks in theory are taking money out of savers’ deposits rather than pay interest. (Banks likely absorb the negative interest cost, sacrificing profits to retain customers’ accounts.) Denmark’s deposit rate is already minus 0.1 percent. If the “real” rate (the nominal rate minus inflation) is negative, savings may still earn interest but the value of the funds erodes with inflation (inflation exceeds the interest rate). Real yields on U.S. Treasuries have been negative since July 2010 and the Swiss three-month Treasury has been negative since July 2011. ^[2]

Source: Richard G. Anderson and Yang Liu, “How Low Can You Go? Negative Interest Rates and Investors’ Flight to Safety.” Federal Reserve Bank of St. Louis. January 2013. Available at: http://www.stlouisfed.org/publications/re/articles/?id=2316&utm_source=Facebook&utm_medium=SM&utm_campaign=Facebook.

Many believe the ECB will have to do more, but it’s doubtful that the governing council meeting Thursday will go beyond taking minor steps, largely to demonstrate its concern for the low inflation. The Bloomberg News survey shows 54 out of 57 economists believe the Governing Council will keep the benchmark interest rate at a record low of 0.25 percent. The three outliers see further cuts to an interest rate between 0.1 and 0.15 percent. ^[3]

April inflation data may show an uptick in inflation, giving the ECB time to build internal consensus. The lone hawk, Weidmann, is now signaling willingness to back some form of quantitative easing should the euro continue soaring in value.

What are the QE options, especially since the territory ahead is uncharted?

Columbia University economics professor Guilermo Calvo prefers a “further relaxation of collateral conditions for access to ECB credit lines.”^[4] Easing access to credit will expand money supply. Others think the ECB must buy back more assets to cut interest rates, as the Federal Reserve did through three phases, starting first with Treasuries and escalating to agency mortgage-backed securities, before “tapering” in June 2013. Federal Reserve holdings are roughly 20 percent of GDP.   Since 2009, the ECB has already been accumulating corporate debt and “sterilizing” (a government bond purchase facility called the Securities Market Program that offers banks interest-bearing deposits equal to the amount of government bonds the ECB holds), its holdings are at an estimated 30 percent of GDP.   Marcel Fratzscher, the director of Germany’s DIW economics institute, estimates that $60 billion monthly is needed by the EBCB to bolster inflation.

This Thursday’s statements from the governing council will provide clues for determining the level of the ECB’s concern about deflation, the outlook, whether it will take more unconventional steps – and more long-term in orientation, and its trigger points for acting.