European Central Bank president Mario Draghi last week gave the strongest indication yet that the bank’s governing council was prepared to embrace ‘unconventional’ policy instruments, or quantitative easing, to tackle the risk of deflation in eurozone economies.
This is a welcome but belated recognition of the fact that monetary policy in the eurozone has been too tight. It is also a vindication of the so-called new market monetarists, who have been consistently critical of the monetary policy pursued by the ECB.
Inflation in the eurozone is running at an annual rate of just 0.5 per cent, well below the ECB’s target of 2 per cent. This in itself is an indication that monetary policy has been too tight.
But other indicators have long been flashing warning signs.
Growth in the M3 measure of the money supply is just 1.3 per cent at an annual rate. Indeed, M3 has been below the ECB’s 4.5 per cent reference rate since the middle of 2009. While the ECB has long paid lip-service to the significance of growth in money and credit aggregates — a legacy of the monetarist intellectual tradition in the German Bundesbank — it has largely ignored this indicator in practice.
Nominal GDP growth has also fallen significantly short of what would be expected based on a 2 per cent inflation target and trend real GDP growth in the eurozone economies of around 1.5 per cent.
The ECB’s official refinancing rate is notable for not having tested the zero bound on nominal interest rates, despite the global financial and European debt crises. Remarkably, the ECB actually raised official interest rates by half a percentage point during 2011 before having to lower them again.
It cannot therefore be argued that the zero bound on nominal official interest rates has constrained ECB monetary policy. Nor can it be said that greater reliance should have been placed on fiscal policy given the failure to make full use of existing monetary policy instruments.
The ECB is constrained by the need to fit a single monetary policy across the diverse eurozone economies. With external devaluation via exchange rate depreciation ruled out for individual member economies, and with the euro foreign exchange rate remaining resilient on the back of tight monetary policy, internal devaluation via disinflation or deflation has set in across the eurozone.
While some degree of miscalibration is inevitable in a single currency area, overall monetary policy has been too tight rather than too easy.
The ECB has previously engaged in asset purchase programs, but these were aimed at improving funding conditions for banks rather than combating deflation.
Questions have been raised about the legality of QE on the part of the ECB. So long as the program is explicitly targeted at euro area price stability and is consistent with a single monetary policy, it should not run into legal barriers.
After cutting its official interest rate to zero in the first half of this year, the ECB will likely engage in outright purchases of private sector assets and government bonds in the second half of the year.
The purchases could be weighted by the capital contributions of member economies to the ECB to ensure they are consistent with a single monetary policy and do not raise concerns that the program is directly financing member governments.
Experience with QE in other economies suggests that the ECB’s asset purchases will need to be sizeable in order to have a significant effect in averting deflation.
The danger is that the ECB’s actions continue to fall short of what is needed to stabilise eurozone inflation and nominal GDP growth. The ECB will likely stress the limited and temporary nature of the asset purchases, undermining their effectiveness, especially if purchases are concentrated in shorter maturity debt instruments.
The eurozone is a case study in the dangers of a single currency. For its part, the ECB is a case study of how modern central banks have over-emphasised official interest rates and inflation as indicators of the stance of monetary policy at the expense of broader indicators such as nominal GDP.
While the ECB is hardly alone in this regard, the monetary policy errors have been more serious and magnified in their effects by the single currency.
Developments in the eurozone economies have largely vindicated the long-standing criticisms of ECB policy made by the so-called new market monetarists, who emphasise the importance of monetary and credit aggregates and nominal GDP as indicators of the stance of monetary policy.
With the US Federal Reserve set to wind back its QE program and the ECB and Bank of Japan set to expand theirs, the US dollar exchange rate should be set for some broad-based outperformance. This outperformance may be tempered, however, if the asset purchase programs of the ECB and BoJ fall short of their stated policy objectives.
Dr Stephen Kirchner is a research fellow at The Centre for Independent Studies.