The European Central Bank is failing in its mandate to keep the rate of inflation in the euro zone close to 2 per cent. Therefore it needs to act and looks likely to do so on Thursday, announcing a programme of quantitative easing (QE) to try to boost inflation. It is important now that the programme is of a sufficient scale to make a difference and that its design is not purely a function of compromise.
The ECB has moved significantly under the presidency of Mario Draghi, in particular his commitment in July 2012 to do “whatever it takes” to protect the euro has had a powerful impact on the financial markets. The immediate threat now is not to the euro itself, but to the economic conditions in the euro zone and the dangers they pose. Consumer prices in the euro area fell 0.2 per cent in December from one year earlier and while falling oil prices were a key factor, the danger is that a deflationary trend sets in, with all its damaging economic consequences.
The vital challenge facing the ECB tomorrow is to alter people’s view of what the future inflation rate is likely to be. QE worked, to an extent anyway, in the US and the UK, even if there will long be debate about what mix of policies contributed to the stronger growth these economies are now experiencing. The ECB has no choice but to follow with its own QE programme, though governments also need to do more to promote growth.
Financial markets expect that the ECB may announce a programme which involves buying upwards of €500 billion of government bonds, effectively trying to lower interest rates charged to borrowers and increase the flow of credit. It is not a programme where success can be guaranteed – official interest rates are very low already, after all, and the euro zone banking system through which credit flows is only gradually working itself back into a healthy position.
However the costs of entering a prolonged deflationary slump more than justify the risks of failure.The ECB simply has no choice but to act and do so decisively. There has been some debate about whether it, or the member central banks should actually purchase the bonds as part of this programme. While we will have to see exactly what is announced, fears that this might put all the risk back on member governments and their central banks may well be misplaced. Still, in communicating the details of this Draghi will need to walk a fine line between German sensitivities and market reaction, both influenced by perception as well as fact.
The ECB move must be big enough and clear enough to have a significant impact. That is the challenge facing Draghi who should also point out that the ECB alone cannot restart growth in Europe and that considerable responsibilities also rest with member state governments.