Yves Nosbusch


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The European Central Bank stands ready to act



euro currencyIn the past, central banks have often had to contend with inflation which was too high. In most advanced economies today, they face the opposite problem: inflation which is too low or even the threat of deflation – a broad-based fall in prices. Deflation can have a damaging impact on the real economy, as illustrated by Japan's experience over the past two decades. First, it leads to a reduction in aggregate demand as consumers have an incentive to postpone purchases if they expect prices to continue falling. Next, it makes deleveraging of the public and private sectors more difficult because the real value of a loan increases mechanically when the overall price level declines. For this reason, central banks want to avoid deflation just as much as overly high inflation. The ECB's objective of keeping inflation close to, but below, 2% in the medium term is consistent with this idea.


The situation in the euro zone
Inflation has slowed markedly in the euro zone since 2012, falling to a low of 0.7% in October 2013. It subsequently rebounded slightly before settling at 0.8% in January and February 2014. The reasons for this slowdown in inflation are partly structural, since there is significant excess capacity and high unemployment in particular which has alleviated wage pressures. But much of the slowdown in inflation since 2012 is explained by falling energy prices and the appreciation of the euro, which has reduced import prices.


The ECB recently presented its latest forecasts for the euro zone. It is predicting a gradual pick-up both in inflation (1% in 2014, 1.3% in 2015 and 1.5% in 2016) and in growth (1.2% in 2014, 1.5% in 2015 and 1.8% in 2016). The inflation forecast for 2014 was revised downwards while the growth forecast was revised upwards.


The ECB is standing pat …
With inflation rates forecast to remain below target for several years, a key challenge for the ECB is to maintain medium-term inflation expectations around its 2% target. For the time being, these expectations, as measured by the Survey of Professional Forecasters, seem to remain stable at a five-year horizon, although they have weakened significantly at the one- to three-year horizons.


The eagerly awaited meeting of the ECB Governing Council on 6 March saw the central bank stand pat, leaving official rates unchanged and announcing no further unconventional measures. Forecasts of a gradual acceleration in growth and relatively stable medium-term inflationary expectations have undoubtedly contributed to this decision. The euro has since strengthened further against the dollar.


… but is ready to act
If measured or anticipated inflation keeps surprising on the downside in the coming months, the ECB could respond. Its president, Mario Draghi, has repeated that the central bank is ready to act. It has several options at its disposal. A first possibility would be a further cut in policy rates. The refinancing rate at which banks obtain ECB funding, which now stands at 0.25%, could be lowered further. The rate banks earn on their deposits at the ECB, currently at zero, could move into negative territory. Then there are more technical measures aimed at increasing overall liquidity in the banking system, including undertaking new long-term refinancing operations, lowering reserve requirements or stopping sterilisation of the Securities Markets Programme.


Finally, three more innovative measures were explicitly mentioned at the ECB's press conference on 6 March. Revitalising the market for asset backed securities could help strengthen the flow of credit to small and medium-sized businesses. A funding for lending scheme along the lines of the UK model could also help to stimulate credit activity. And the ECB could undertake a large-scale bond purchase programme (Quantitative Easing). This last approach, already used in the United States, Japan and the United Kingdom, would perhaps be the most direct way to tackle the slowing pace of inflation.



Article completed on 14 March 2014 by Yves Nosbusch, Chief Economist of the Bank
Published in the Luxemburger Wort (in French) on 14 March 2014