Praet Says Forward Guidance on ECB Rates Wouldn't Work

European Central Bank Executive Board member Peter Praet said entering into a Federal Reserve- style commitment to keep interest rates low for longer wouldn’t work in the euro area.

“Engaging in promises regarding the future monetary-policy stance would not be the most effective instrument” in a highly- fragmented currency region, Praet said in a speech in Copenhagen today.

Such a commitment is “in principle applicable” when broad-based economic stimulus is needed in regions with “more or less homogeneous” financing conditions, he said. “Despite the notable improvements recently, this by and large is not the situation we are facing in the euro area.”

With interest rates at a record low of 0.75 percent, unlimited liquidity provision to the region’s banks and a commitment to buy bonds of distressed nations, the ECB is getting closer to the limits of its toolbox. That’s left economists pondering new measures it could apply if the economy, which is battling its second recession in four years, doesn’t gather pace in the coming months. In the U.S., the Federal Open Market Committee said last month it will keep interest rates near zero as long as the jobless rate is above 6.5 percent and inflation is forecast to be 2.5 percent or less. Previously policy makers said they would keep rates low through at least mid-2015.

Higher Inflation

Economists including Olivier Blanchard of the International Monetary Fund floated higher inflation targets as one option to stimulate growth as early as 2010.

Lifting the limit for inflation in the 17-nation region is not an option for the ECB, Praet said.

“It may not surprise you to hear that I am very skeptical about this proposal,” he said. Changing the inflation target “on tactical grounds would be opportunistic and would harm the credibility of the central bank.”

A loss of credibility could propel inflation expectations, which “would require a disproportionate withdrawal of monetary policy accommodation in the future to reign in inflation,” Praet said. “Any initial boost to economic activity will therefore ultimately be more than reversed. Additional and unnecessary volatility in real activity would be the price to pay.”

Gradual Recovery

The euro area succumbed to recession in the third quarter as governments from Greece to Spain cut spending to rein in excessive deficits. ECB President Mario Draghi said on Jan. 10 that economic weakness is expected to continue.

The ECB lowered its forecasts in December and predicts the economy will shrink 0.3 percent in 2013, with a “gradual recovery” later in the year.

The economic environment remains “challenging,” Praet said. “The arsenal of the ECB’s instruments for monetary policy implementation continues to be able to” ease funding conditions “when this is deemed necessary.”

While unlimited allotment in refinancing operations with a maturity of as long as three years “has proven to be very powerful,” it isn’t “free of pitfalls,” Praet said. Long-term lending expanded the ECB’s balance sheet to more than 3 trillion euros and increased the share of banks’ assets that are pledged as collateral and unavailable for other operations, he said.

That’s why the ECB allows banks to repay emergency three- year loans early, Praet said.

Early Repayment

“We will exert vigilance to ensure that –- notwithstanding the legitimate decisions of individual banks to reduce their liabilities to the central bank -– the overall liquidity conditions prevailing in the money market will remain consistent with the degree of accommodation that the current outlook for prices and real activity warrant,” Praet said.

Some 278 financial institutions will return 137.2 billion euros tomorrow, the first opportunity to return the funds, the ECB said last week. The ECB flooded financial markets with more than 1 trillion euros of three-year loans in late 2011 and early 2012.

“I am convinced that our existing monetary policy framework provides enough scope for instruments to continue addressing the crisis in a decisive and effective way,” Praet said. “We remain attentive to possible shortcomings in our policy framework and to changes in the structure of the economy that would warrant revisiting aspects of this framework. At present, however, I see no compelling case for change.”

To contact the reporters on this story: Stefan Riecher in Frankfurt at sriecher@bloomberg.net; Peter Levring in Copenhagen at plevring1@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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