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The ECB's Dilemma

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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As its governing council prepares to meet in Frankfurt on Thursday, the European Central Bank finds its scope for action influenced not just by regional issues but also by the world's other systemically important central banks.

The ECB is wedged uncomfortably between, on one side, the Federal Reserve -- which is able but unwilling to venture deeper into unconventional monetary policy -- and on the other, the Bank of Japan and, to a lesser extent, the People's Bank of China, which remain willing to do more, but with measures that appear increasingly ineffective in supporting economic activity.

QuickTake Negative Interest Rates

Treading this delicate balance, the ECB is likely to opt to do more. Yet, even though its incremental unconventional measures are likely to still have an impact in the short-term, the central bank will be getting closer to the point of being increasingly ineffective and perhaps risk being counterproductive.

ECB officials will be under significant pressure to expand the bank's support for a European economy that is losing growth momentum and has recently seen its inflation rate go negative. To this end, they will be tempted to increase the pace of monthly large-scale purchases of securities, the program known as quantitative easing, and could go even further in pushing interest rates negative and altering the rate structure.

Such actions would contrast sharply with the path taken by the Fed, which has exited its quantitative easing program and, for the first time in almost 10 years, has increased interest rates -- not because the U.S. economy has achieved liftoff, but because officials are increasingly worried about the collateral damage and unintended consequences of excessive and prolonged reliance on central bank policy experimentation.

Instead, the ECB would be moving closer to its counterpart in Japan, which is struggling to deliver on stated objectives, even though it surprised markets recently with extensive stimulus measures.

Although there is no certainty about the continued potency of experimental policies, the ECB's actions this week are likely to have some impact on the exchange rate and financial asset prices, as well as the potential for some beneficial economic spillovers.

Specifically, they probably would help weaken the euro, which would support exports and import-substitution activities. And they are likely to help European equity markets out-perform, at least in relative terms, which would help at the margin to shore up consumption.

Yet these short-term effects will dissipate rapidly unless they are supplemented by a broader European policy shift -- away from excessive reliance on the ECB and toward a comprehensive policy response that turbocharges pro-growth structural reforms, addresses aggregate demand deficiencies, deals with remaining pockets of excessive indebtedness and strengthens the regional economic and financial architecture.

Moreover, as Fed Chairman Ben Bernanke said in August 2010, the "benefits" of unconventional policies come with "costs and risks."

The European economy's continued excessive reliance on the central bank is increasingly becoming a more tenuous proposition to defend, as it increases the political vulnerability of the ECB and undermines its longer-term policy effectiveness, creates a more difficult environment for banks, and distorts the allocation of capital. Indeed, the ECB could be vulnerable to following Japan's path, seeing declining benefits outweighed by rising costs and risks.

When the Bank of Japan stunned markets a few weeks ago by taking interest rates negative, it probably didn’t anticipate what followed: a stronger (rather than weaker) currency, a stock market selloff (rather than a rally), a furious parliament demanding explanations, and evidence of increased disintermediation by households from the banking system. This is a vivid reminder that, beyond a certain point, prolonged unconventional central bank activism -- especially when it involves negative nominal interest rates -- can go from being part of a short-term solution to causing complications that are not easy to contain.

The main question to ask before the ECB's meeting should not be whether officials will do more. They will. Rather, it is how quickly they will inadvertently approach the unfortunate situation that the Bank of Japan now finds itself in – that of reduced policy effectiveness and increase political vulnerability.

No one who cares about the health of Europe and the global economy would want another systemically-important central bank getting to that stage.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net