Is the European Central Bank (ECB) doing enough? Next week, ECB president Mario Draghi is expected to reiterate his promise not to change interest rates this year, in part because falling unemployment points to “gradually rising inflation pressures”. Such a stance is being criticised by economists on three grounds.
One is that the economy is in bad shape. Official figures next week are expected to show that industrial production is still significantly lower than it was in the autumn. And the weakness might well persist: purchasing managers reported this week that manufacturing orders are falling at their fastest rate since 2012.
A second problem has been pointed out by Zsolt Darvas, an economist at the think-tank Bruegel. He shows that the ECB’s inflation forecasts have been “systematically incorrect” since 2013. It has consistently forecast a rise in core consumer price inflation (CPI) inflation, which has not materialised. If we exclude energy and seasonal food (prices of which cannot be controlled by central banks) the inflation rate now is 1.2 per cent – which is what it was in 2013. The ECB’s track record, therefore, suggests we should have little confidence in its belief that inflation will rise towards its target of just under 2 per cent.
There is a Phillips curve in the eurozone: since 2002 there has been a significant negative correlation (of minus 0.63) between unemployment and core CPI inflation in the following 12 months. But it is quite flat – in this time each percentage point drop in unemployment has added only 0.25 percentage points to inflation. Inflation, then, isn’t terribly responsive to the state of the labour market.
A third problem is that the ECB’s negative interest rates are costing banks money – because they have to, in effect, pay a tax on the cash they deposit with the ECB. This matters: the less profitable banks are, the less keen they will be to lend to businesses (although of course as investors in Deutsche Bank will tell you, the ECB is by no means the only problem for banks’ profits).
Mr Draghi and Peter Praet, the Bank’s chief economist, are aware of this problem and are thinking of ways to tackle it. Several economists, however, doubt they will do enough. ECB members, says Daniel Stewart's Alastair Winter "are sounding increasingly at a loss."
Eric Lonergan at M&G has suggested one solution. He says it should raise the deposit rate to zero (thus removing the tax on deposits with the ECB) and cut the rate on targeted longer-term refinancing operations – the money it lends to banks to lend on to businesses – to well below zero. In effect, then, the ECB would subsidise banks more. Because central banks cannot run out of money, they can give banks a sufficiently large subsidy to boost lending and hence economic growth and (eventually) inflation.
In truth, though, there is a simpler way to kick-start economies when interest rates are at zero: to relax fiscal policy. In the absence of a central fiscal authority, however, this is difficult to do for the region as a whole. Such an absence is a flaw in the design of the euro. It might not be a fatal flaw. But it does mean that the euro zone is, says John Llewellyn of Llewellyn Consulting "a floundering, export-dependent, institutionally compromised economy facing political uncertainty."
