Unpalatable choices

SINCE the financial crisis the European Central Bank (ECB) has ploughed a solitary course, reflecting its unique status as a monetary authority without a state. While other big central banks, notably America’s Federal Reserve, adopted quantitative easing—buying government bonds by creating money—to stimulate recovery, the ECB relied mainly on lowering interest rates and providing unlimited liquidity to banks on longer terms and against worse collateral. But as the Fed phases out its asset-buying programme in 2014, it may be the ECB’s turn to become unorthodox.

Under Mario Draghi the ECB has taken bold steps. Two years ago it provided banks with €1 trillion ($1.3 trillion) of cheap three-year variable-rate loans to avert a funding crisis. In September 2012 it countered euro break-up fears by pledging, if necessary, to buy unlimited amounts of government bonds for countries besieged by the markets. But the threat now is a slide towards deflation, a worry in the euro area because debt is high in many states and deflation raises its burden in real terms.

Over the past year inflation has slid from 2.2% to 0.9%, well beneath the ECB’s target of “below but close to 2%”. An unexpectedly sharp drop in inflation last autumn prompted the ECB to cut its main lending rate in November from 0.5% to 0.25%, a new low. It also extended its undertaking to provide banks with unlimited amounts of short-term funding until mid-2015. And it reiterated its version of forward guidance, adopted in July, which is to keep interest rates at their current or lower levels for an extended period.

In December Mr Draghi argued that monetary policy was sufficiently loose to keep deflation at bay but conceded that inflation will remain low for a prolonged period. The ECB forecasts inflation falling from an average of 1.4% in 2013 to just 1.1% in 2014, and then picking up modestly to 1.3% in 2015. That is already weak, which means that if inflation does drop further (the forecast envisages it could be as low as 0.6% this year) the ECB will have to do more.

A first step could be a further small cut in the lending rate, to 0.1%. Beyond that the ECB has three main options: strengthening its forward guidance; setting negative interest rates; and quantitative easing.

Since the council’s declared policy is that of forward guidance, reinforcing it would make sense. Other central banks provide harder guidance. The Fed and the Bank of England have tied pledges not to raise rates to explicit thresholds for unemployment (and even then not to treat these as automatic triggers). As Willem Buiter of Citigroup points out, the ECB’s version could be hardened if the bank were to do another long-term liquidity operation at a fixed rate (either 0.25%, or 0.1% if it cut again). That would enhance the credibility of the guidance and help to keep forward interest rates very low. The policy would come in handy if the Fed’s decision to start tapering its asset purchases in January pushed up global interest rates.

Introducing negative rates would be more radical but consistent with the current version of forward guidance, which applies to all the bank’s policy rates. The rate that would go negative is the one the ECB pays on overnight money left with it, which since July 2012 has been zero. A negative deposit rate would in effect charge banks for parking spare funds at the ECB. Though this would be unprecedented for the euro area, Denmark went negative in July 2012 (in response to the ECB’s zero rate) in order to deter inflows of foreign funds that were putting upward pressure on the krone and threatening its peg to the euro.

The case for the ECB going negative is broader than that for the Danish central bank. Owing to the fragmentation of the euro zone, the deposit rate mainly affects banks in northern creditor countries, which can access the money markets. If the deposit rate turned negative, this would ease money-market rates because it acts as a floor for them. This would help to stimulate activity in northern Europe and might ease upward pressure on the euro, which has been uncomfortably strong for export businesses. An even bigger prize would be if the policy restored a euro-zone interbank market by nudging northern banks to lend again to their southern counterparts, which have been relying on central-bank funding.

But that gain would be elusive if northern banks continued to ostracise southern banks on the ground they are still too risky. And going negative could backfire. Banks would be likely to restore any erosion in their profit margins by raising their lending rates, which would defeat the purpose of the exercise.

Such worries about negative rates might lead the ECB to consider the third option. Quantitative easing would help to stave off deflation by lowering long-term interest rates and shoring up the money supply, which is barely growing (see chart). It is a strategy that has been used by central banks in Britain and Japan as well as by the Fed. If the ECB were to follow suit, it would have to buy in secondary markets a basket of bonds reflecting the economic weight of the 18 euro-zone countries (nearly 30% would thus have to be German).

Of the options available, this is the one that most clearly tackles the deflation risk. But it is particularly difficult to adopt because the Bundesbank opposes bond-buying on the ground that it blurs monetary and fiscal policy, especially in a currency union where there is no equivalent to federal American debt. In December Yves Mersch, a member of the ECB’s executive board, said that purchasing a basket of government bonds would pose “immense economic, legal and political challenges”.

The ECB wants to avoid having to grasp any of these nettles. It is keener on influencing market expectations through talk and threats rather than deeds. But another downward lurch in inflation may force its hand, in which case 2014 will be the year when the ECB goes unconventional.