Mario Draghi's Policy Dilemma
Pity European Central Bank President Mario Draghi. He will face a dilemma at the bank's policy-making meeting Thursday, as markets urge him to cut rates further, even to push some important benchmark bonds deeper into negative yields. If he resists these pressures, he risks dismantling a central-bank-created confidence bubble that, while imperfect, is key to Europe's growth strategy. But if he chooses to accommodate markets' demands, he could aggravate a risk of future financial instability that already was highlighted in the ECB’s own Financial Stability Review last week.
European economic and financial conditions have been improving, but they are far from solid. Growth remains rather sluggish, and not strong enough to overcome protracted pockets of over-indebtedness in certain countries. Joblessness remains alarmingly high in some nations, particularly for the young and the long-term unemployed. The terrorist attacks in Paris are affecting France's gross domestic product and accentuating deflationary pressures. And these economic weaknesses are compounded by the wavering of political will to complete the region’s historic economic integration project, which is being challenged by disagreements over how to deal with the refugee crisis, including whether to maintain the border-free Schengen arrangement.
Not surprisingly, markets expect the ECB, as the union's most engaged and consistent policy-making entity, to take out some additional insurance this week by reducing its deposit rate and/or extending its large-scale securities’ purchase program, which would contribute to a further loosening of liquidity conditions and a depreciation of the euro.
But if market participants view such a course of action as the obvious choice, economists, including those at the ECB, see things in a more nuanced fashion.
The unconventional monetary policy approach carried out by several central banks around the world has yet to bring about a sustained large increase in economic activity, including in the U.S. where such macroeconomic policy experimentation was introduced earlier than in Europe. Meanwhile, there are mounting concerns about unintended consequences and collateral damage.
Last week, the ECB's semiannual Financial Stability Review warned that the monetary policy approach adopted by the advanced economies contributes to “misaligned asset prices.” As a result, the “possibility of an abrupt increase of risk premia at the global level has become more pronounced.”
The report also advised that the threat of future global financial instability was further accentuated by the likelihood of policy divergence among systemically important central banks. Although it is maintaining a stimulative stance, the Federal Reserve is expected to hike rates for the first time in almost 10 years at its December policy-making meeting. By taking a different path, the ECB would add to the risk of interest-rate and exchange-rate volatility that could derail economic performance, including in the emerging world.
These conflicting considerations highlight once again the extent to which Europe has been deprived of first best policy conditions by the inactivity of national policy-making institutions. Like other central banks, the ECB is forced to continue to carry a policy burden that is far too heavy, and without the necessary tools to complete the task.
Faced with a choice between two tricky options, the Draghi-led ECB is likely to opt to do more rather than less.
As it takes additional measures, the bank will highlight the need to support the region’s economic recovery, and will note that any risks to financial stability could be countered through the use of its macroprudential policies.
That, at least, will be the message to the general public. Behind closed doors, however, the ECB may rue the unhealthy symbiotic relationships that central banks around the world have developed with financial markets. This dependence has made markets overconfident of the power of central banks to continuously decouple asset prices from fundamentals. The central banks, in turn, are forced to use this confidence bubble to keep economies humming, albeit at a low equilibrium, until politicians finally step up to their economic governance responsibilities.
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