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Two ECB Board Members Warn of Risk in Loose Monetary Policy

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Feb. 27 (Bloomberg) -- Two European Central Bank Executive Board members today warned of the risks in leaving emergency monetary stimulus in place for too long.

“The maintenance of our extraordinary measures over a too-long timeframe creates false incentives and leads to moral hazard,” Yves Mersch said in his first speech as an ECB board member in Frankfurt, adding that a retreat from certain emergency measures “would be desirable because new market distortions could otherwise develop.” In a separate speech, board member Peter Praet said there’s a risk that the ECB’s policies will become less effective the longer they are left in place.

The ECB has cut its benchmark interest rate to a record low of 0.75 percent, extended over 1 trillion euros ($1.3 trillion) in cheap loans to banks and pledged to buy the bonds of debt-strapped nations if they agree to economic reforms. ECB President Mario Draghi said today that while the central bank is “far” from considering tightening monetary policy, there are limits to what it can do.

“It is important to stress that the ECB’s mandate only extends so far,” Draghi said at event in Munich. “There are clear limits to what monetary policy can and should aim to achieve. We cannot repair unsound budgets. We cannot clean up struggling banks. We cannot solve deep-rooted problems in the structure of Europe’s economies.”

Banking Union

Mersch said the region’s proposed banking union can strengthen the foundations of the single currency and ease the load placed on monetary policy.

The banking union can help “dissolve blockages in the transmission mechanism of monetary policy,” he said. “Then the emergency kit of monetary policy in the crisis won’t be needed to the same extent, so that one can phase out or unwind emergency measures. That’s not to be mixed up with a divergence from accommodative monetary policy.”

Praet said ECB stimulus could become less effective the longer it is relied upon.

“I am referring to what used to be known as ‘instrument instability’ in policy-making,” he said. “The need to apply larger and larger doses of the same policy interventions only to see their macroeconomic influence becoming more and more tenuous.”

Weakened Incentives

Expectations that interest rates will remain low for a long time and that abundant liquidity will be provided “might weaken the incentives for banks to downsize operations and repair their balance sheets,” Praet said, adding that the ECB has “all the necessary instruments” to reduce liquidity in the financial system.

The provision of emergency liquidity assistance, or ELA, by national central banks in the euro region can only be a temporary fix because it risks undermining the ECB’s single monetary policy, Mersch said.

“Monetary-policy tensions are built up between the national and the European level, which shouldn’t be permanent,” he said. “A re-nationalization of the monetary-policy architecture wouldn’t be helpful.”

To contact the reporter on this story: Jana Randow in Frankfurt at jrandow@bloomberg.net

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

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