IMF Urges ECB to Expand QE If Inflation Doesn’t Revive

  • Euro zone urgently needs comprehensive plan for bad loans: IMF
  • Downside risks to euro-area economy have grown, fund says

The International Monetary Fund urged the European Central Bank to consider expanding its asset-purchase program if inflation in the euro area doesn’t rise from current low levels.

“Given the very weak outlook for inflation, the ECB should stand ready to ease further if inflation remains below its anticipated adjustment path,” IMF staff said Friday in an Article IV report on the euro area. “Dis-inflationary pressures remain strong with 11 countries reporting negative inflation in May” and “with second-round effects weighing on core inflation.”

Under the guidance of the ECB, central banks in the euro area are currently spending 80 billion euros ($89 billion) a month, the vast majority on sovereign bonds, to drive up an inflation rate that hasn’t reached the institution’s goal of just under 2 percent for more than three years. Officials currently predict consumer-price growth will accelerate to 1.6 percent in 2018 from 0.2 percent this year.

Even as the 19-nation economy enters its 14th quarter of expansion, unemployment is still above 10 percent at a time when the U.K. vote to leave the European Union risks damaging the recovery.

“Downside risks have grown,” the IMF said. “External demand could weaken, while political risks have risen significantly, particularly related” to the situation in the U.K.

Brexit Fallout

The IMF cut its 2017 growth forecast for the euro area to 1.4 percent from the 1.6 percent it predicted in April, citing the U.K.’s June 23 referendum. The Washington-based fund sees the region’s economy expanding 1.6 percent in 2016.

“The U.K. is an important trading partner for the euro area, as the destination for about 13 percent of euro area exports, and also has close financial links with the region,” the IMF said in a supplement to the report. “Its exit from the EU is expected to negatively affect euro area economies through trade, financial and confidence channels.”

While negative interest rates have helped the euro area economy, further cuts may show diminishing returns, meaning the ECB’s focus should be on its asset purchase program, according to the IMF.

“Further cuts could weigh on bank profitability,” the IMF staff said. “And additional 2.4 trillion euros of assets” would be available to buy, which “could more than accommodate a one-year extension of the program. Modest changes to the program could dramatically increase the scope for more purchases,” it added. Allowing the purchase of bonds below the deposit rate, for instance, would be helpful, the report suggested.

Bank Worry

The IMF also expressed concern about euro-area banks and the impact of non-performing loans.

“A time-bound, comprehensive strategy is urgently needed to address the NPL problem and can be part of a broader strategy for promoting consolidation in some banking systems,” the fund’s staff said.

Italian authorities are racing to shore up a financial system burdened by about 360 billion euros ($399 billion) of troubled loans, amid the ECB’s increasing pressure on Italian lenders to clean up their balance sheets and tackle troubled loans that are undermining lending. Prime Minister Matteo Renzi is exploring measures to support Banca Monte dei Paschi di Siena SpA and other weak banks after Britain’s vote to leave the EU exacerbated a selloff in Italy’s lenders.

State intervention to support Italian banks may be needed, Bank of Italy Governor Ignazio Visco said Friday. “Given the risk that, in a context of high uncertainty, limited problems could undermine the trust in the banking system, a public intervention cannot be excluded,” Visco said in a speech at the Italian Banking Association’s annual meeting in Rome.

“In systemic cases where state intervention may be warranted, EU State Aid rules should be exercised flexibly as permitted, recognizing that the correct determination of ‘market prices’ is difficult without a functioning market,” the IMF said.

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