Why Draghi was right to cut ECB interest rate
Euro zone risks falling into deflation
A Berliner at the launch of the euro in 2002. Many in Germany might conclude that they would be better off outside the euro zone.
The monetary policy of the European Central Bank has been too tight. This is shown in the fall of core annual inflation to just 0.8 per cent in the year to October 2013. The case for the monetary easing undertaken last week was overwhelming. Indeed, it was long overdue.
Yet, it has been leaked, the decision to cut the refinancing rate from 0.5 per cent to 0.25 per cent split the council. Both German representatives – Jörg Asmussen, a member of the ECB’s board, and Jens Weidmann, head of the Bundesbank – as well as the heads of the central banks of the Netherlands and Austria voted against this move.
Open splits on national lines have emerged previously, but only over controversial programmes such as the securities markets programme, launched under Jean-Claude Trichet, Mario Draghi’s predecessor as president of the ECB, and the outright monetary transactions programme, launched by Draghi in the summer of 2012. Both of these initiatives were intended to relieve market pressure on sovereign bonds.
That was bound to be controversial, given German hostility to monetary financing of governments. But such splits over standard monetary policy decisions are new. This matters: they endanger the legitimacy of the ECB – and so of the monetary union.
Some have even accused Draghi of acting in the interests of Italy – and the objections of German representatives to the easing are bound to stimulate such suspicions. Yet the case for a cut in the ECB’s standard policy rate is, in truth, overwhelming: core inflation is now less than half the ECB’s target of “below, but close to, 2 per cent”.
As Draghi argued, there are compelling reasons for not putting up with inflation below that level.
First, an inflation rate recorded at 2 per cent might, in truth, be close to zero: inflation is almost certainly exaggerated at the moment in conventional measurements.
Second, needed changes in competitiveness inside the euro zone would be difficult even if average inflation were 2 per cent. They would be far harder at close to zero, given the resistance of workers to nominal wage cuts.
Third, monetary policy tends to be more ineffective the closer inflation comes to zero, partly because depressed economies may well need negative real interest rates – which are much easier to implement when inflation rates are positive.
To these I would add a fourth: the euro zone risks falling into deflation, given excess capacity and high unemployment. The ECB says that inflation expectations are anchored. That might prove hubristic.
It is easy to identify other reasons why policy has been far too tight. Between the first quarter of 2008 and the second quarter of 2013, nominal euro-zone demand expanded by just 1 per cent. Nominal gross domestic product grew by a mere 3.4 per cent. Moreover, so-called M3 money – a measure of the “broad” money supply – has been virtually stagnant since late 2008.
What, then, are the arguments against last Thursday’s decision? One was that the decision could well be postponed. But it has already been postponed too long: the longer the delay, the greater the danger. A second concern is that this move brings unconventional measures even closer. But the less promptly the ECB uses conventional measures, the greater the likelihood that extreme ones will be needed. If the ECB had moved rates decisively towards zero in 2010, it might have avoided at least some of today’s difficulties.