Draghi must be more unconventional

25/10/2015

By Wolfgang Münchau

The eurozone’s economic recovery is again weakening before it really started

Mario Draghi last week opened the door for some lateral thinking on eurozone monetary policy. At the meeting of the governing council of the European Central Bank, the bank’s president hinted they would have to take a deep look at all the monetary policy instruments available at their next meeting in December

This is both welcome and unfortunate — welcome in terms of what it says about his determination to get inflation back to target; unfortunate because it should not have been necessary. The eurozone is once again in a position where economic recovery is weakening before it really started, where the global risks are rising, and where inflation remains way off target.

So what should this lateral thinking consist of? An extension of the ECB’s programme of quantitative easing beyond its scheduled cut-off date of September 2016? Another cut in interest rates?

This is what the consensus opinion expects, but that would be vertical thinking, not lateral. It would also be ineffectual. Lateral thinking should take us outside conventional approaches.

We should start reminding ourselves of the reason why we are in this miserable position only nine months after the start of QE. The ECB and other forecasters were simply too optimistic about the impact of this relatively small programme on inflation. Headline inflation in September was exactly where it was in March. Core inflation went up from an annual rate of 0.63 per cent in March to 0.88 per cent in September, an increase of a quarter of a percentage point.

The latter constitutes a fair metric of the programme’s success. Most of that was probably due to a one-off effect — the end of the credit crunch in the Italian banking sector. QE has really helped Italy. It was worth doing it for that reason alone. But this also means that the effect of QE from now on is not going to be all that large.

The governors of the ECB may want to reflect on how an extension of QE could get inflation back to its target, and what other conditions will need to be put in place for that to happen. Would QE work better if eurozone governments were to incur higher fiscal deficits?

Matteo Renzi, the Italian prime minister, is currently using every trick in the book to circumvent European budget rules. His previously planned spending cuts are lower; the tax cuts are bigger — and of the wrong kind; and against the advice of the European Commission, he is now cutting unpopular property tariffs instead of labour taxes.

But can the ECB find a politically feasible way to support Mr Renzi’s fiscal expansion when Germany and others are consolidating? Are there other ways for the ECB to create aggregate demand in the economy?

The governors might also want to reflect on the inflation target itself, and ask themselves whether one of the reasons they are in this current mess is because of how the inflation target is formulated in the first place: a rate of inflation of below, but close to 2 per cent.

Done to please the Germans in the early years of the euro, this formulation leaves too much wiggle room for interpretation. I know economists in Germany who consider any inflation rate above 1 per cent as consistent with the target. And for them, the current core inflation rate of 0.9 per cent hardly constitutes sufficient reason to roll out the next monetary bazooka.

I am wondering whether the governors would do themselves a favour by simply clarifying their target — not to raise it, but simply restate it as 2 per cent, no more, no less.

That would get rid of any doubt about the trajectory from where we are now to where we have to go. The previous intellectually lazy generation of central bankers thought ambiguity was useful to them. The current generation has learnt that ambiguity works against them.

We are not yet at the point where the governors will consider truly radical proposals — such as an increase in the inflation target or a nominal gross domestic product target, let alone the nuclear option of a monetary helicopter drop. They will first try to exhaust the existing instruments to their limits.

Central bankers are conservative types. But they should have a rational interest in preventing a loss of their credibility.

My advice to them is first extend the current programme to its outlier limits — another year of QE — agree another cut in the deposit rate and look at the addition of other instruments to the mix, like corporate bonds.

But much more importantly: have a genuine radical plan B ready to unroll in 2016, ahead of the next shock you did not see coming. You will need it.

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