Draghi as Sisyphus

Inflation in the euro zone has been below 2% for three and a half years now  and under 1% for almost two years, with the latest figure for August at 0.2%. Many people would think this a good thing in a period of very modest wage growth, as it supports real incomes, but it is a failure for the ECB , as its goal is price stability, which it defines as inflation  close to but below 2%. Very low inflation risks deflation in the Bank’s view and although the inflation trend is heavily influenced by weak commodity prices core measures are also weak: excluding food and energy,  inflation was 0.8% in August, indicating very little price pressures.

The ECB was slower than other Central Banks in cutting interest rates but the main refinancing rate is now at zero alongside a negative deposit rate of -0.4%, all designed to encourage banks to lend into the real economy. That approach reflects the importance of banks in the EA as the main providers of credit and the ECB has recently gone further down that particular road, with its  latest TLTRO scheme, allowing participating banks  to access  four-year funds at an interest rate which could fall to the -0.4% deposit rate depending  on lending growth. In other words the ECB could end up effectively paying some banks to lend money.

The ECB also decided to by-pass the banking route by embracing QE, with the purchase of government and corporate bonds designed to push down longer term rates. To date , some €1,165bn assets have been purchased, including over €940bn in government bonds, with the programme currently projected to run until March 2017.

Has any of this worked? Growth in the EA is averaging  around 0.4% per quarter, hardly stellar, but sufficient to put downward pressure on the unemployment rate, which has fallen to 10.1% from a peak over 12%. Bank credit has also started to rise, from a very weak base, with  lending to the private sector growing at an annual 1.7% rate in July and the ECB has been keen to point out that the cost of funds for EA banks in general has fallen steadily as a result of monetary policy decisions.

Yet credit growth is still contracting in many countries, including Ireland, despite ample liquidity. Indeed, data from the Central Bank here shows that in July deposits in Irish banks exceeded loans, a far cry from the 190% loan to deposit ratio seen pre-crisis. This highlights that in some countries deleveraging is still a dominant force and there are other factors at work, including capital issues for some banks, the scale of non-performing loans and the appetite from lending institutions to take on risk.

Negative rates are also an issue, in that they are putting downward pressure on net interest margins; banks are reluctant to cut deposit rates below zero but many of their loans are linked to market rates, which are falling. Initially the ECB was loathe to accept this point, arguing that higher loan growth would be an offset, but in the  minutes of the last Council meeting there was concern expressed  about the profitability of EA banks and their low stock market valuations, increasing the cost of capital for banks and hence reducing lending.

These concerns may dissuade the ECB from further cuts in the deposit rate and they also face problems with QE, in that the universe of government bonds available for purchase is shrinking, and in some cases the 33% issuer limit is likely to become a binding constraint- that will be the case in Ireland, for example. The ECB could change that limit or extend its purchase of corporate debt, although the latter already moves the Bank into allocating credit directly, which may make some Council members uncomfortable as well as stretching its mandate..

The bigger question is whether all this is having any impact on inflation and the answer would appear to be in the negative. Rather than increasing the bet, the ECB might reconsider its whole approach, with a growing  number of policymakers across the globe examining the case for more expansionary fiscal policy. On that point it was notable that the Fiscal theory of the Price Level got an airing at the recent Jackson Hole gathering, with a paper delivered by Princeton’s Christopher Sims, who is closely associate with that approach. The theory is that the price level is influenced by fiscal policy as  well as monetary policy, and argues that low interest rates  can be deflationary , in that they reduce debt service for governments and unless offset by higher spending or tax reductions will result in contractionary fiscal policy.

Generating inflation in the current environment requires much more expansionary fiscal policy, it is argued, and we may indeed end up with a changed fiscal approach in some countries, including the UK, albeit for different reasons. That appears very unlikely in the EA however, and President Draghi may end up like the legendary Greek king, doomed to push a boulder up the hill only to see it always roll back.