A Monetary Game Plan for the ECB

November 22, 2013
  • The ECB can and should do more to boost lending in the euro area.
  • The central bank could lower the policy rate further and accelerate money supply growth.
  • The ECB could also create a negative deposit rate, provide banks with liquidity, and adopt a version of the U.K.'s "funding-for-lending" scheme.

Earlier this month, the European Central Bank surprised markets by lowering its main refinancing rate by 25 basis points to 0.25%. Yet the ECB can and should do more to boost lending in the euro zone. It can lower the policy rate further and accelerate money supply growth, introduce a negative deposit rate, provide banks with liquidity, and adopt a version of the U.K.'s funding-for-lending scheme.

A Bloomberg survey found 60% of economists in favor of the ECB's rate cut, a surprisingly slim consensus. The euro area unemployment rate remained 12.2% in September; in July, joblessness reached 26.6% in Spain and 27.6% in Greece. Inflation has continued to slow, reaching 0.7% y/y in October from 1.1% the previous month, well below the ECB's 2% target. Finally, the euro's valuation rate is still high at $1.35 against the dollar. The question is not why the ECB lowered its policy rate, but why it has not done more to reignite the euro zone economy.

A one-sided mandate

A partial explanation of the ECB's conservative attitude is its mandate, which allows the bank to focus solely on price stability. Yet this has not stopped the central bank from considering business cycles when it sets monetary policy. Like other central banks, the ECB follows the so-called Taylor rule, which calls for increasing the policy rate to fight inflation and decreasing it to reduce unemployment. With inflation below 2%, the rule actually suggests a negative policy rate.

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Although Germany's lower unemployment rate justifies a higher policy rate than does the wider euro zone, Germany’s anemic 0.3% output growth in the third quarter suggests it could benefit from a lower rate as much as Spain. A strong case can therefore be made for lowering the policy rate to zero.

While the policy rate cannot go below that zero bound, the rate the ECB pays on commercial bank deposits can. If the ECB imposed a negative rate, banks would be charged for keeping funds at the central bank, encouraging them to increase lending instead. ECB President Mario Draghi has said the bank is ready to impose a negative deposit rate, as Denmark's central bank already does. Doing so would be useful, although bank deposits with the ECB have recently declined, leaving less to be freed up for lending.

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The risk of deflation in the euro zone is clearly greater than the risk of inflation. The most troubled euro area economies such as Spain, Portugal and Cyprus have ratios of private debt to GDP above 200%. This is in addition to very high levels of public debt. Falling prices make debt burdens worse, while modest inflation would ease the load without restructuring, since private debt is a liability for consumers and firms, but an asset for commercial banks.

Stress tests coming

The ECB will conduct a risk assessment of 130 financial institutions across the euro area, followed by stress tests conducted jointly with the European Banking Authority in mid-2014. It is unclear what the ECB will do if it concludes that some institutions are undercapitalized. The central bank lacks both the authority to close these banks and the funds to recapitalize them. While the European Stability Mechanism was established with this issue in mind, its lending capacity is only €500 billion and it comes with strings attached, with governments guaranteeing the repayment of the loans.

The ECB might therefore consider alternatives to bank restructuring. Increasing the money supply would effectively lower the policy rate, which is how the Bank of Japan has stopped the deflation spiral in that economy. Over the last year, money supply growth in the euro area has been comparable to that in the U.K. and Japan, but much lower than in the U.S. Increasing the money supply would only marginally affect a policy rate already close to zero, but it could ease deflation pressure and weaken the currency.

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The euro zone ran a trade surplus of €13.1 billion in September, driven mainly by Germany. At first glance, the euro appears to have an elevated value against the U.S. dollar, but this is largely a function of lower interest rates in the U.S., which make U.S. financial assets less attractive and lower the demand for the greenback. Faster money supply growth and a lower policy rate in the euro zone would put downward pressure on the euro's exchange value.

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Following the example of the Federal Reserve and the Bank of England, the ECB introduced its own version of forward guidance in July when it promised not to raise rates for at least a year. This period could be extended. A zero policy rate would lower unemployment only through the end of 2016, according to Moody's Analytics' model. This suggests the ECB should keep the policy rate at 0% at least that long, raising it only after the unemployment rate falls below 8.8%, the estimated natural level of unemployment.

Liquidity risks

To address liquidity issues, the ECB flooded the market with just over €1 trillion in three-year loans to some 800 euro zone banks in 2011 and 2012. While the first deadline for repayment under the Long-Term Refinancing Operation is January 2015, euro area banks have already repaid €380.7 billion. Banks worry that the European Banking Authority may penalize them for overreliance on the LTRO in the coming stress tests. As a result, the ECB's balance sheet is shrinking. Although additional LTROs would serve to postpone dealing with solvency problems, the ECB will consider them to make sure there is sufficient liquidity in the financial system.

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One tool the ECB is not using is quantitative easing, via the purchase of long-term debt securities to support their prices and lower market interest rates. The Federal Reserve has been buying $85 billion a month in Treasury and mortgage-backed securities since December 2012. The ECB briefly engaged in a similar operation when it purchased Italian and Spanish sovereign debt, but the program was discontinued after the ECB announced its so-called Outright Monetary Transactions scheme in 2012. The OMT program, a pledge to buy government debt that has never been actually implemented, succeeded in lowering the cost of borrowing for governments, but not for firms, especially in the southern euro zone.

More creativity needed

The ECB needs to be more inventive to boost lending in its troubled economies. It could try a more comprehensive version of quantitative easing, purchasing corporate as well as sovereign debt, but this is unlikely as euro zone firms rely mainly on banks for credit. A second option would be a program similar to the U.K. "funding-for-lending" scheme, which lowers banks' funding costs as long as the money is lent to households and small businesses.

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Most economists surveyed think the ECB will offer another round of LTROs and perhaps cut the policy rate. However, the ECB should also introduce some version of the "funding-for-lending" scheme, use negative deposit rates, grow the money supply, and provide more explicit forward guidance.

Petr Zemcik is a Director of Economic Research at Moody's Analytics.

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