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Appraising the European Central Bank
Hard talk, soft policy
The ECB has run as loose a monetary policy as other central banks have. It is just rather more coy about it
THE global economy has stopped sinking and central bankers are pausing for breath. As The Economist went to press on July 2nd, the European Central Bank (ECB) was expected to keep its main “refi” interest rate unchanged, at 1%. The ECB’s rate-setting council has been chary of cutting rates closer to zero as policymakers elsewhere have done. Its reluctance to do more has attracted criticism, only some of it fair.
The focus on policy rates may put the ECB in a bad light but these are no longer a reliable guide to the overall monetary-policy stance. If you look at market rates the policy stance in the euro area is as loose as anywhere else, because of stimulus decisions taken at the height of the financial crisis. In October the ECB decided it would offer banks as much cash as they wanted, at a fixed interest rate (the refi rate) and against a wider range of security than usual, for up to six months. It also scheduled extra three-month and six-month refinancing operations, so that banks could come more often to the central-bank well.
In May the ECB council agreed to extend the offer of fixed-rate cash to one year. At the first 12-month refinancing operation on June 24th, euro-zone banks borrowed a staggering €442 billion ($620 billion). With so much cash splashing around, the charge that banks make for overnight loans has stayed well below the refi rate, with some occasional spikes (see chart). Since the €442 billion cash injection, overnight interest rates in the euro zone have fallen to a record low of 0.3%, below those in Britain and scarcely higher than in America. Indeed banks can now borrow more cheaply in euros than in pounds for either three, six or 12 months.
Before the crisis, the ECB would aim to keep overnight interest rates close to the refi rate. Since it moved to unlimited fixed-rate funding, the central bank has been content to allow the overnight rate to drift much lower than the policy rate. In effect, the bank now has a target range for short-term rates: the upper bound is the 1% refi rate and the lower bound is the rate the central bank pays on banks’ deposits with it, currently 0.25%. The deposit rate has been a better guide to the policy stance than the refi rate has. ECB-watchers and markets understand this, even though it has not been spelt out in so many words by Jean-Claude Trichet, the ECB’s president.
Why be so coy? One concern is that by playing up the fight against recession, the ECB could appear to have lost sight of inflation. Keeping the totemic refi rate above zero may be seen as necessary to prevent inflation expectations to drifting up. There may also be a reluctance to admit that such a gushing provision of liquidity has altered the policy stance. Since the start of the crisis in August 2007, the ECB has insisted the two are separate. “They are bold on liquidity because they don’t see it as mainstream monetary policy,” says Charles Wyplosz of the Graduate Institute in Geneva. Yet the terms of its refinancing for banks have clearly led to looser monetary conditions.
Another reason for obfuscation is to mask differences among rate-setters. Monetary-policy hawks can reassure themselves that the policy rate is not too low. Doves are happy that effective interest rates are nearer to zero. And Mr Trichet can claim there is a “consensus”. The terms of the truce make it easier to reverse policy when the time comes. By restricting its liquidity support, the ECB will be able to guide overnight interest rates towards 1% without having to alter its policy rate.
Because the ECB has had one eye on the exit since the start of the crisis it has earned plaudits to those who think the Federal Reserve has been incautious. That judgment is too kind to the ECB, which could afford to have scruples about the medium term because other central banks were taking more care of the present. It is also unfair on the Fed, which had to stand in place of America’s collapsed shadow-banking system. When the economy was in most danger, the ECB could have cut rates more quickly. “If the ECB had been more proactive, the recession would have been less bad,” says Marco Annunziata of UniCredit. The striving for consensus militated against bolder action.
Another criticism is that the ECB has not done more to ease credit conditions by buying government and corporate bonds outright, as the Bank of England and the Fed have done. Its scheme to purchase up to €60 billion of the safest bank bonds, launched this month, is modest by comparison. Mr Trichet believes that focus makes sense, as euro-zone businesses and homebuyers rely more on banks than capital markets for credit. In America, capital markets matter more, so the Fed had to get its hands dirtier by buying commercial paper and mortgage-backed securities.
The ECB is also loth to soil its hands with public debt, though banks flush with central-bank cash are keen buyers of such low-risk assets. If this is monetisation at a remove, so be it. The central bank keeps its independence to government and does not have to worry about selling bonds back into the market once the interest-rate cycle turns. “If you want to stay clean, the exit strategy is easier,” says Thomas Mayer of Deutsche Bank.
But offering ample liquidity support to banks gets you only so far. By buying assets, the Fed allows American banks to shed them, freeing scarce capital for fresh lending. As losses mount in the euro zone, capital may trump liquidity in determining credit growth. Lending to the private sector slowed to 1.8% in the year to May, an all-time low. Until credit starts to revive, the ECB cannot think about tightening policy. It may yet have to be bolder.
A new economic era is dawning
SOMETIMES you can have too much news. There was so much financial turmoil in the autumn that it was hard to keep up with events. In retrospect it is clear that a change in the economic backdrop akin to the demise of the Bretton Woods system in the early 1970s has taken place. Investors will be dealing with the aftermath for decades to come.
From the mid-1980s onwards the answer to big financial setbacks appeared to be simple. Central banks would cut interest rates and, eventually, the stockmarket would recover. It worked after Black Monday (the day in October 1987 when the Dow Jones Industrial Average fell by 23%) and the Asian crisis of 1997-98. It did not rescue shares after the dotcom bust but the easing led to the housing boom and the underpricing of risk in credit markets.
Easing monetary policy was pretty popular. It lowered borrowing costs for companies and homebuyers. To the extent that savers earned lower returns on their deposit accounts, they were usually compensated by a rebound in the value of their equity holdings.
Indeed, monetary easing appeared to be costless. When policymakers cut interest rates in the 1960s and 1970s they often ignited inflationary pressures. Not so in the 1990s. Whether that was down to the brilliance of central banks or the deflationary pressures emanating to China and India is still a matter of debate.
This time around conventional monetary policy has not been enough. The authorities have also had to resort to quantitative easing, using the balance-sheets of central banks to ensure the funding of clearing banks and to keep the lid on bond yields. And there has been a huge dollop of fiscal easing. Some countries’ budget deficits have soared to 10% of GDP.
The fiscal packages have proved rather less popular than monetary easing. Initially they were seen as bail-outs for greedy bankers. But the focus of criticism has shifted to the deterioration of government finances and the potential for higher future taxes, borrowing costs and inflation.
An eerie parallel seems to be at work. There was a time, back in the 1950s and 1960s, when Keynesian stimulus packages were seen as costless. Governments thought they could fine-tune their economies out of recession. Eventually it was realised that the ultimate result of too much stimulus was higher inflation and excessive government involvement in the economy. Keynesian demand management was abandoned in favour of the monetary approach. The past couple of years have demonstrated that the use of monetary policy had its costs too, not in consumer inflation but in rising debt levels and growing asset bubbles.
The authorities never even considered allowing the financial crisis to continue unhindered. The damage to the economy would have been too great. But the costs of this latest round of government action will be big. Investors will have it in mind during the next boom that governments will rescue the largest banks, slash rates, intervene in the markets and run huge deficits. In other words the moral-hazard problem will be even greater.
Before we get there, however, the authorities will have to work out an exit strategy. Past cycles have shown that the tightening phase, after a long period of low rates, can be very dangerous. Bond markets were savaged in 1994 when the Federal Reserve started to raise rates to 3%. What will bond markets do if central banks also unload the holdings acquired during the crisis? And how will stockmarkets perform if interest rates and taxes are being raised at the same time?
Given these risks, the new era will surely be a lot more fragile than the one that prevailed in the 1980s and 1990s. There is simply more scope for policymakers to go wrong.
In addition, the global financial system has lost its anchor. When Bretton Woods broke down and the last link to gold was severed, there was in theory nothing to stop governments to creating money. It took independent central banks, armed with inflation targets, to reassure creditors. But now central banks have shown they have another priority apart to controlling inflation: bailing out the banks.
The new era is one in which governments are using floating exchange rates, near-zero interest rates and vast fiscal deficits to protect their economies. None of this is good news for creditors, who will surely not put up with the situation for long. The actions they take to protect their portfolios—demanding higher bond yields, pushing for fixed exchange rates—will define the next economic system.
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