ECB president Mario Draghi can pull one more rabbit out of his hat before he leaves
As we count down the days to Mr Draghi’s departure, expectations are building
Mario Draghi has worked nothing short of monetary miracles over his eight-year term as European Central Bank president through a sequence of unconventional policy interventions. As we count down the days to Mr Draghi’s departure, expectations are building once again that he will be able to pull one final rabbit out of the hat.
Whether long-term loans to banks, a conditional safety net underneath the sovereign bond market, negative rates or quantitative easing, Mr Draghi coaxed and cajoled his colleagues on the Governing Council into delivering it. The naysayers in financial markets might say it has all been for naught. Try telling that to the near 11 million people who have found work since the trough in 2013.
Still, here we are approaching Mr Draghi’s end of term and once again there is a clamour for Mr Draghi to cut interest rates further into negative territory and to launch another round of asset purchases. There is no crisis demanding an immediate response. But global headwinds threaten to stall the recovery and the outlook for inflation remains a cause for concern. Inflation is stuck below, but not close to, the ECB’s target and with every passing month it becomes more likely that households and companies will expect it to remain that way. Another dose of monetary stimulus is clearly required if the central bankers are serious about achieving their mandate.
However, it is not quite that simple. The economy is not in dire straits, and without a crisis many, if not most, of Mr Draghi’s colleagues may remain unpersuaded of the case for action. And his capacity to convince them to act sooner might finally be fading as his date of departure approaches.
Most important of all, it has become harder to do more. The deeper rates go into negative territory, the more you have to worry about the unintended consequences. At some point cutting rates can become counterproductive. When it comes to buying bonds, the ECB has imposed constraints upon itself, which would soon bite if quantitative easing was restarted on a meaningful scale. Those constraints can be lifted, but not without a a degree of soul searching over whether the ECB would be in breach of rules for bailing out governments.
So what should Mr Draghi do? Perhaps he will be able to work his magic one last time and convince his colleagues to act. But that looks a tall order unless there is some significant change in the global outlook. There is a sensible alternative: extract a credible commitment today from his colleagues to act in the future if certain conditions are met. Mr Draghi’s latest speech suggests he is moving in this direction.
The commitment would come in the form of a statement that the ECB will take certain actions under certain conditions. The broad contours of that statement are clear. For example, the ECB will resume asset purchases if inflation is no longer considered to be on a sustainable path back to the target. Unfortunately, this form of words leaves far too much latitude in the hands of his successor on when to act.
In theory, the ECB would describe a threshold level or path for inflation – for example, a lower bound on the end point of its inflation forecast – below which it would be compelled to restart asset purchases. And ideally, as well as describing when the ECB should start using unconventional measures, the commitment should also address when the ECB would stop. That is, the ECB would continue asset purchases until inflation was expected to be back above that threshold. Of course, ECB forecasts are notionally produced by the staff and not the policymakers so the Governing Council would have to take ownership of the numbers if they are going to determine whether or not the ECB restarts QE - but that would be no bad thing.
Mr Draghi’s colleagues will be uneasy about having their hands tied in this way. But this form of words does nothing more than commit them to respect their existing mandate. Economic theory suggests that a far more aggressive ambition - keep easing policy until inflation overshoots the target - could be very effective but it is hard to imagine Mr Draghi convincing his colleagues to make that commitment, and even if they did so, it is hard to imagine them sticking to it. This brings us to credibility.
If Mr Draghi is to convince investors that his colleagues will deliver on the commitment even when he is no longer in the room then he will need to remove the institutional and intellectual impediments that might delay or derail action once he is gone. If investors and economists worry that the ECB is running out of room to cut rates, then Mr Draghi should commission research from his staff to estimate where the true lower bound lies and publish the results. If the market is concerned that the ECB is running out of room to buy more bonds then officially take the decision now that the limits on the amount of each bond issue the ECB can purchase would be raised in the event of a resumption of quantitative easing.
For the moment, these would merely be options. Rates would remain where they are and the reinvestment policy as bonds mature would respect the existing issue limits. The point is that policy space would have been clearly established. And ideally Mr Draghi could secure unanimity within the Governing Council on these decisions - something his colleagues might be willing to give in preference to acting today. Of course, Mr Draghi would probably prefer to act sooner. But a credible conditional commitment for the future is a lot better than doing nothing at all.
Updated: June 24, 2019 04:41 PM