The ECB's dilemma

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

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.

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 largescale 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 mar- kets 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.

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