The ECB has been slow in responding to the financial crisis that has persisted for years. Its most recent policy package is an important step in accommodating the eventual economic recovery in the eurozone.
The European Central Bank responded quickly but relatively cautiously to the global financial crisis. It introduced liquidity measures as early as 2007 and, when the crisis intensified, it gradually lowered its policy rate to 0.25%. The ECB also introduced a number of measures in the early days of the crisis intended to ensure that there was sufficient liquidity in the banking system. While central banks in other major economies such as the US and the UK hit the zero lower bound on their policy rates and quickly moved on to a new policy tool of liquidity injections, the ECB’s liquidity provisions were not meant to create more monetary accommodation, but instead to facilitate the transmission of its stance as represented by its own policy rate. The growth of the balance sheets of these central banks during the crisis, one among the possible parameters used to gauge the expansiveness of monetary policy, illustrates the relative caution of the ECB’s policies (Figure 1).
As early as 2009, financial conditions had improved in the eurozone and the ECB began to “phase out” its non-standard policies. Tensions in sovereign debt markets, however, escalated financial fragmentation within the eurozone leading the ECB to introduce the Securities Markets Programme (SMP) and reintroduce the non-standard liquidity measures it had phased out early on. While the ECB reacted to the events of the day, the US Federal Reserve (Fed) and the Bank of England (BoE) maintained their highly expansionary monetary policy when the economic outlook took a brief upturn after its initial slump.
In addition to balance sheet growth, inflation trends in these three major economies during the crisis also reveal a significantly more hawkish response by the ECB (Figure 2). All of these economies experienced inflation volatility during the crisis. In fact, the US and the eurozone followed very similar trends in inflation until recently, but the central banks’ responses were very different. Despite ongoing weakness in the eurozone economies, the ECB raised rates in mid-2011 in response to upside risk in prices. The Fed as well as the BoE, which was observing much higher inflation, however, kept their policy rates firm at the zero-lower bound and even introduced new expansionary measures during this time.
When Mario Draghi took the ECB’s reins in late 2011, the policy rate was decreased back to its crisis levels and additional liquidity measures were introduced in response to new tensions in financial markets, and downside risks to prices and the real economy. In the summer of 2012, Draghi announced the controversial Outright Monetary Transaction (OMT) program. Although no operations have been conducted to date under the OMT program, the announcement soon had a big impact on market expectations and facilitated a gradual reduction in financial fragmentation in sovereign debt markets (Figure 3).
Unlike other major central banks, the monetary policy of the ECB during the crisis has been marked with hesitation and even retreat unduly fearing “price pressures.” However, the persistence of low-flation, stagnant credit growth, and the outlook of a protracted period of low output and high unemployment have led the ECB to recently introduce a new expansionary monetary policy package. The new measures aim to ease funding conditions, stimulate credit provision to the real economy, and enhance the functioning of the monetary policy transmission mechanism. Policy measures include eight rounds of targeted long-term refinancing operations (TLTROs) over the next few years, reducing the key policy rate to its zero-lower bound, a negative deposit rate, an asset-backed securities purchase program, suspending sterilization of liquidity injected under the SMP, and a third round of the Covered Bond Purchase Program (CBPP3) which involves the outright purchases of covered bonds – debt securities that are an important source of funding for banks in the eurozone.
Amid one of the most aggressive monetary policy offensives in the eurozone since the crisis began, one must still wonder: Just how expansionary is the ECB’s current monetary policy stance? The ECB’s balance sheet has actually been slowly shrinking since 2012 and currently sits at the same levels as it did in the fall of 2011, before the three-year LTROs (Figure 1). Although the measures introduced in June will increase the ECB’s balance sheet, repayments of three-year LTROs are currently shrinking the balance sheet at a steady pace. The ECB’s policies are still nowhere near as expansionary as the Fed’s or BoE’s, even after the new measures take effect. Furthermore, the first allotment of TLTROs underwhelmed expectations. The next allotment of TLTROs set for December is expected to be larger after the results of the ECB’s comprehensive assessment are released and the Single Supervisory Mechanism is launched.
The recent decision of the ECB to cease sterilization of liquidity injections under the SMP also indicates openness to more expansionary balance sheet policies. As Draghi recently explained, “the main reason to commit to sterilization…was based…on the potential effects that this additional liquidity might have on inflation. When the SMP started, the inflation rate was above 2%.Nowwe are in a completely different world, so that now this decision actually takes place in the background characterized by low inflation, a weak recovery, weak monetary and credit dynamics.”
The success of the new monetary policy measures will depend on whether they can reach domestic demand through credit channels. Of central importance is the reduction of financial fragmentation. The ECB’s 2014 release of the Financial Integration in Europe report indicates that progress in reducing financial fragmentation has been made, but it still remains a concern. Specifically, fragmentation in borrowing costs to nonfinancial corporations, particularly for SMEs, is hindering economic activity in the already stressed eurozone countries. These results are reinforced by the ECB’s Survey on the Access to Finance of Enterprises (SAFE) which revealed that between October 2013 and March 2014, access to finance remained the first most pressing concern for SMEs in Greece, and second most pressing concern for SMEs in Ireland, Italy, Portugal, and Spain. During the same period, it remained the least pressing concern for SMEs in Germany and Austria. Most recently, however, persistent underperformance in gaining momentum in the projected recovery appears to have created an upward trend in fragmentation in 2014. Thus, it is too soon to tell whether the recent policy measures will reverse this trend.
The ECB’s recent policy actions aim to address persistent low-inflation in the eurozone and to reduce financial fragmentation. The latter is important for facilitating credit to the market segments that can benefit most: firms and consumers in the eurozone countries under stress. It is still unclear, however, whether boosting inflation is the key to the recovery. Identifying the source of disinflation in the eurozone is important for explaining whether price dynamics are encouraging internal adjustment or merely impeding the recovery. If disinflation is being driven by weak labor markets and economic activity, it may create a self-fulfilling prophecy as debt dynamics worsen, leaving less fiscal flexibility, and wage adjustments become more difficult, hurting firm competitiveness. On the other hand, if disinflation and deflation are being driven by wage inflation then this would indicate that internal adjustments are underway that could serve to boost domestic activity over the medium to longer term as competitiveness improves.
There are currently six countries in the eurozone experiencing deflation: Estonia, Greece, Italy, Portugal, Slovakia and Spain. Wage deflation has been relatively strong in two of these countries over the last few years (Greece and Portugal), while others have experienced some downward pressure on wages (Italy and Spain). Therefore there is a connection between the countries that are experiencing price deflation and those that are experiencing wage deflation. There is also a strong positive correlation between the inflation and the growth rate of wages during the crisis across all of the eurozone countries. However, this correlation is significantly weakened when measured during the period since it began to fall (2011Q4 to 2014Q2). Furthermore, when we only restrict the sample to the 11 largest economies in the eurozone (excluding Cyprus, Estonia, Latvia, Luxembourg, Malta, Slovakia, and Slovenia) the correlation between these variables during the crisis begins approaching zero.
In general, it appears that downward wage pressures probably have some effect on price inflation. At the same time, low domestic activity and weak labor markets in the countries under stress could be causing both wage and price deflation as employers gain more bargaining power and the declining or stagnant demand for consumer goods and fixed investments drag down prices. In addition, if the eurozone were experiencing internal adjustment, countries with relatively higher demand would observe upward pressure on prices and wages. Instead, the eurozone is experiencing disinflation across a majority of its member countries and a significant portion of the goods in the HICP basket. Even in Germany where economic activity has improved and the unemployment rate is 4.9%, it is still experiencing downward price pressures with an inflation rate of 0.8%.On the whole, these trends appear to suggest that downward pressure on both prices and wages across the eurozone reflect stagnant domestic activity and weak labor markets.
The ECB has acted relatively cautiously every step of the way during the seven-year bout of weak economic activity, financial fragmentation, and sovereign debt troubles. Its recent policies, although relatively broad, may still fall short of the confidence boost the eurozone needs. In order to have an impact on inflation, the ECB’s policies need to reach domestic demand and labor markets. The ECB’s recent monetary policy announcements have caused the euro to fall 10 cents on the US Dollar since May 2014. This is important for sustaining strong foreign demand in the eurozone. The announcements have also eased credit conditions throughout the eurozone. And yet, the ECB is once again called to secure public and market confidence by showing it is both capable and willing to act without hesitation. Let’s hope it succeeds.