The European Central Bank (ECB) is under pressure to react to the deteriorating macroeconomic conditions in the Eurozone but President Mario Draghi may be reluctant to take bold steps ahead of the end of his term in October.
In March, the ECB formally reversed a commitment to hiking interest rates by the summer of 2019 and took an expansionary turn as growth and inflation forecasts have been revised downwards in Germany, France, and Italy.
Last week, the ECB committed to retaining unchanged interest rate policy, that is, is a negative 0.6% for deposits and 0% for refinancing. The ECB is also committed to buying sovereign bonds at the current levels at least until the end of the year. In addition, the ECB is committed to replacing current provisions for refinancing sovereign and banking debt (TLTROs) with new measures.
The technical indicator for Eurozone “investors’ inflation expectations” has fallen to its lowest level since August 2014. For a while, the ECB’s €2.6 trillion government and corporate bond-buying programme appeared to be putting inflation back on a 2% trajectory. However, new data suggests that the Eurozone is nowhere near its policy target.
In December 2018, when the ECB was heading towards an interest rate hike, inflation was in the region of 1.6%. Currently, inflation stands at 1.36% – the lowest level since 2016.
There are a number of measures under consideration to bolster the Eurozone’s resilience to the current economic downturn.
First, the ECB is rethinking its negative interest rates, which are effectively a tax on banking reserves. The ECB is said to be considering the Japanese model of using a tiered system of negative rates on liquid deposits, excluding a share of lenders’ reserves. This measure alone could halve the estimated annual cost of €7.5 billion of negative interest rates to the banking sector while boosting profitability.
Secondly, the ECB could follow the US Fed policy of increasing the inflation target to above 2% to counterbalance a prolonged period of exceedingly low inflation.
Going beyond these measures could be seen as infringing on the mandate of the next president of the ECB who will succeed Draghi in October.
While the markets would expect Draghi to do whatever it takes to align inflation with expectations, many of his possible successors may be more conservative and less willing to prolong the period of unorthodox monetary policy.