Blog Post

Easing now or later?

There is almost no doubt that the ECB will need to loosen up its monetary stance a bit more, the question is when to do so?

By: Date: November 18, 2013 Topic: European Macroeconomics & Governance

October euro area annual overall inflation is expected to be 0.7% (the lowest in 47 months and down for the fourth consecutive month), while core inflation (excluding energy, food, alcohol and tobacco) is estimated at 0.8%; down from 1.1% and 1.0% in September respectively, according to a flash estimate from Eurostat This is below but far from the 2% target.

Source: ECB

At the same time the euro touched an almost two year maximum against the dollar two weeks ago reaching 1.38 against the dollar (25 months maximum on a weighted basis against its 12 major trading partners[1]); of course the euro is a freely floating currency, thus the resulting loss of competitiveness that weighs on the euro area recovery is not of the ECB’s concern, but an appreciation of the euro puts further downward pressure on inflation as imports become cheaper and there is a pass-through effect.

Source: ECB

Euro area unemployment rate closed at 12.2% in September, GDP growth is expected to contract 0.6% this year and grow by only 1.1% next year, while inflation is expected to close this year at 1.4% and 1.3% in 2014, according to Eurosystem Staff June projections. In this context of sluggish recovery why doesn’t the ECB do more to keep inflation close to the 2% target as its mandate indicates?

Orphanides and Wieland (2013) developed an interest rate rule that explains with incredible accuracy the ECB’s chosen MRO rates since the beginning of the euro. Using inflation expectations from the latest ECB Survey of Professional Forecasters, forecasted GDP growth from the Eurosystem Staff projections and potential GDP growth from AMECO (as the ECB doesn’t publish its official potential GDP estimations), this interest rate rule suggests that the ECB’s MRO should be between 0.325 and 0.575 to keep annual inflation in the euro area between 1.5% and 2% [2].

Source: Bletzinger and Wieland (2013)

So, if the ECB keeps behaving like it has been doing in the past, the 0.7% inflation in October might not be sufficient to make the ECB staff uncomfortable enough to ease momentary policy a bit more, or at least not for the moment, as inflation expectations are still anchored at 1.5% in the medium term and at 2% in the long term.

The main scenario for most investment banks forecasters is just dovish talk and a rate cut later in December, as more weak data confirms the need for a rate cut.

What are the risks of easing monetary policy in the euro area too late?

If the ECB fails to be aggressive enough this Thursday (and the now usual dovish talk without any immediate action is clearly not going to be enough), the euro is likely to further appreciate and this would put additional downward pressure on prices through cheaper imports and even slower aggregate demand, as European exports would become less competitive in the world markets. This would change expected inflation and growth, forcing the ECB to ease monetary policy later, so it is probably better to do it now and avoid more pain.

If everything is so clear, why is the ECB so reluctant to loosen up its monetary stance a bit more?

There are reasons beyond the usual argument of inflation being just round the corner as few people fear nowadays, but many used to presage when central banks of the advanced economies started using unconventional monetary policy tools at the beginning of the crisis.

The first reason is that the ECB is running out of ammunition in the conventional monetary policy toolkit; cutting the MRO rate once more would be literally hitting the ZLB, only leaving the marginal lending facility rate with some space for further cutting. But as ECB Executive Board member Joerg Asmussen said almost a month ago, they “also have the whole array of non-standard measures left, from the famous LTRO to using reserve requirements to discontinuing the weekly absorption operation”. He also mentioned that the ECB could stop taking weekly deposits to offset money injected into markets via its Securities Markets Programme bond-buying plan.

The second is the broken monetary policy transmission mechanism. Previous rate cuts have proven to be ineffective to bring down borrowing costs where it is most needed (the periphery) because of the non-existence of a banking union and the sovereign-banks linkage, a topic that has been broadly covered in Bruegel’s research. With conventional monetary policy partially effective at most, the ECB could choose to go unconventional this time, with another round of LTRO being a quite popular possibility.

Conclusion

There is almost no doubt that the ECB will need to loosen up its monetary stance a bit more, the question is when to do so? Given the current shape of the economy, the case for keeping the rate unchanged is weak; it would be difficult to argue against a sooner rather than later easing of monetary conditions in the euro area for the sake of faster recovery and price stability.


[1] ECB Nominal effective exch. rate, ECB EER-12 group of currencies (AU, CA, DK, HK, JP, NO, SG, KR, SE, CH, GB, US), changing composition of the euro area against Euro

[2] Updating the Orphanides and Wieland (2013) interest rate rule with the new MRO rate (0.25), the most recent forecasts from the ECB Survey of Professional Forecasters (1.5% inflation one year ahead) and ECB Staff macroeconomic projections (0.9 percent of real GDP growth one year ahead and 0.5 percent of potential GDP growth), give us as result that if the ECB followed the OW rule it would keep the MRO rate between 0.2 and 0.45 percent to keep inflation between 1.5 and 2 percent. We could also interpret from this that given the current conditions the ECB won’t further loose its monetary stance unless another unexpected negative shock (of any kind: real, financial or just agent’s expectations) hits the euro area economy.  This does not imply that it will be appropriate not to loosen up the monetary policy a bit more through unconventional monetary policy tools to help the recovery while keeping inflation closer to the target.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read about event More on this topic

Upcoming Event

Oct
23
12:30

Europe: Back to the future of a political project

This event will feature a discussion on different ideas for reforming European Governance.

Speakers: Ulrike Guerot, Adriaan Schout and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

The international use of the euro: What can we learn from past examples of currency internationalisation?

The recent State of the Union speech by Jean-Claude Juncker sparked a discussion about the potential wider use of the euro on the international stage. Historically, it is not the first debate of this kind. Emmanuel Mourlon-Druol analyses four previous cases of debates on international currencies to reveal the different scenarios associated with their greater use, as well as the need to have a clear objective for a currency’s internationalisation.

By: Emmanuel Mourlon-Druol Topic: European Macroeconomics & Governance Date: October 15, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: How does Italy’s budget fit with EU fiscal rules?

In this Director’s Cut of ‘The Sound of Economics’, Guntram Wolff welcomes Bruegel research fellow Grégory Claeys to assess how the new Italian budget proposals measure up against the existing EU fiscal rules.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: October 9, 2018
Read article More on this topic More by this author

Opinion

Greece: What to expect after the bail-out

After being under the close scrutiny of three financial assistance programmes since May 2010, Greece has finally left the bail-out in August 2018. How different is the post-bail-out era from the preceding eight years? Will Greece be able to stand on its own? And how might the country improve its economic outlook? In this post, which summarises a presentation recently given at an Athens conference, the author answers these three questions.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: October 9, 2018
Read article More on this topic

Blog Post

Improving the efficiency and legitimacy of the EU: A bottom-up approach

The 2019 European elections promise to be a watershed moment for the EU. A recent Bruegel paper made the case for restructuring the Union’s model of governance and integration. The authors of this post critically assess this proposed institutional engineering, and argue for the principle of “an ever closer union” to be safeguarded by a bottom-up approach to respond to the common needs of the citizens.

By: Silvia Merler, Simone Tagliapietra and Alessio Terzi Topic: European Macroeconomics & Governance Date: October 9, 2018
Read article More on this topic

Blog Post

Italy’s new fiscal plans: the options of the European Commission

The Italian government has announced an increase of its deficit for 2019, breaking the commitment from the previous government to decrease it to 0.8% next year. This blog post explores the options for the European Commission and the procedures prescribed by the European fiscal framework in this case.

By: Grégory Claeys and Antoine Mathieu Collin Topic: European Macroeconomics & Governance Date: October 8, 2018
Read article More on this topic More by this author

Blog Post

One club does not fit all in Europe

In this column, Jean Pisani-Ferry argues how the EU can become a more effective global player, following the Policy Brief "One size does not fit all: European integration by differentiation.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: October 2, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: Is economics asking the right questions?

Bruegel deputy director Maria Demertzis welcomes Financial Times commentator Martin Sandbu to explore the journey taken by the field of economics since the financial crisis struck 10 years ago, and discuss what new tools economics has now that it didn’t have then.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: October 2, 2018
Read article More on this topic More by this author

Blog Post

Digesting the Salzburg Summit

As the moment of truth for Brexit negotiations is approaching, with the October European Council around the corner, we review opinions on the outcome and meaning of the Salzburg summit.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: October 1, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: The Italian government budget proposal for 2019

Guntram Wolff welcomes Bruegel affiliate fellow Silvia Merler to evaluate the Italian government’s planned budget for 2019, in this Director’s Cut of ‘The Sound of Economics’

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: September 28, 2018
Read article Download PDF

Policy Contribution

European Parliament

Excess liquidity and bank lending risks in the euro area

In this Policy Contribution prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON) as an input to the Monetary Dialogue, the authors clarify what excess liquidity is and argue that it is not a good indicator of whether banks’ have more incentives in risk-taking and look at indicators that might signal that bank lending in the euro area creates undue risks.

By: Zsolt Darvas and David Pichler Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: September 26, 2018
Read article More on this topic More by this author

Blog Post

Something Putin and Juncker appear to agree on – the euro

“It is absurd that Europe pays for 80% of its energy import bill – worth €300 billion a year – in US dollars when only roughly 2% of our energy imports come from the United States,” said President Juncker in his state of the union speech.* Europe’s largest supplier of energy – Russia, who accounts for a third of that bill – couldn’t agree more. Russia’s offer to switch to euros in trade with the EU will likely be costly to implement, but the US switch towards unilateralism is forcing its long-standing partners to question the dollar’s global dominance.

By: Elina Ribakova Topic: European Macroeconomics & Governance Date: September 25, 2018
Load more posts