ECB President Mario Draghi has put the ECB under enormous pressure to act on Tuesday with an announcement that has come as a complete surprise and is in my opinion economically incomprehensible: he said that the ECB was considering further monetary stimuli if inflation failed to pick up and there were no signs of economic improvement in the coming weeks. In a move most unusual for a central bank, Draghi has explicitly demanded an improvement in the economic situation and higher inflation expectations. This of course means that the current situation has taken the ECB by surprise, or that actions in recent weeks have been too hesitant. A further interest rate cut was explicitly announced and – if this were to prove insufficient – another asset purchasing programme.
In purely formal terms, the new monetary orientation might have been prompted by the visible decline in inflation expectations, and, in particular, the longer-term inflation expectations which – despite the extended forward guidance – have again fallen noticeably since the last ECB meeting. However, the question here is whether this decline might not be attributable to global factors (decline in crude oil prices, global economic weakness). Bearing these circumstances in mind, it is more than doubtful whether a 10 basis point reduction in the deposit rate will actually help to achieve the ECB’s objective. If this step proves insufficient, market players will be relatively quick to demand the asset purchasing programme being signalled by Draghi.
Given the limited room for manoeuvre, the ECB’s announcement really does come as a surprise. The global economy is cooling down, and a further ease in ECB monetary policy will do little to prevent that. Inflation expectations have indeed fallen, but most likely primarily due to external factors which the ECB is also unable to influence. One spinoff from this announcement is the clear support for Italy, as the country will again have to pay less for financing its debt.
The long-term consequences which Draghi would then no longer need to correct could, however, be fatal. What’s at stake ultimately is the credibility of the ECB: i.e. what happens if the announced measures fail to have any effect, a prospect that in my view is quite likely. The ECB will then be faced with the dilemma of a persistently weak economy, continuously low inflation and a steadily deteriorating fiscal situation, especially in Italy. Bund yields will be even more negative than they are at present, while yields in Italy and similar countries can be expected to have risen noticeably by then. But the ECB will have no other cards to play. At the final count, the ECB’s extreme monetary course will be interpreted as support for countries unwilling to undertake structural reforms. This could prove detrimental to the ECB as a whole. To rectify this situation, the ECB might then be compelled in an inopportune moment to make a monetary policy U-turn – with negative consequences for the euro zone economy.
The ECB’s monetary decisions appear cut and dried. While it is difficult to foresee the consequences, they could prove very negative. Unfortunately, the ECB Governing Council lacks a corrective instance, and also offers no insight into how decisions are made. It would be desirable for an institution as important as the ECB to gear its decision-making processes more strongly to democratic principles and be subject to control although this should not be allowed to obstruct the ECB in fulfilling its monetary tasks.