As Long as It Takes

The European Central Bank (ECB) made no changes to its policy stance when the Governing Council met in Vienna on 2 June. Price inflation in the euro area remains well below the ECB’s definition of price stability and the prospects for inflation to move upward remain unchanged. Nevertheless, ECB President Mario Draghi argued in response to questions during his press conference, ‘we have to see the full impact of the measures that we’ve decided in March.’ Some of those, like the targeted long-term refinancing operations that offer to subsidize bank lending and the inclusion of corporate bonds in the ECB’s large-scale asset purchases will only start over the coming weeks. It takes time for such measures to work their way through to the consumption and investment that drives the real economy. And for those who complain that the ECB seems slow in meeting its policy target, Draghi made it clear that: ‘the medium term for a return to inflation to our objective of an inflation rate of close to but below 2 percent is pretty long.’ In other words, the ‘medium term’ from the ECB’s perspective is essentially as long as it takes.

Unfortunately for the Governing Council, there are limits to how long that can be. The reason, as Draghi acknowledged both during his press conference and during a speech he delivered to mark the 200th anniversary of the Austrian National Bank, is that the ECB’s unconventional monetary policy measures create ‘distortions’ that increase over time. These distortions are really distributive consequences. They are the winners and losers that result from the ECB’s intervention in the markets. As the ECB purchases assets, for example, it delivers wealth both to those who sell at higher prices and those who hold onto their positions (as least so long as the policy continues or until the economy recovers enough for the assets to be worth the high prices that the ECB is willing to pay). The ECB also benefits those who need to borrow money through its policy of ultra-low interest rates.

By contrast, the people who hold assets that the ECB is unwilling to purchase do not benefit as much, except perhaps when investors who sell to the ECB look for something cheaper and yet riskier to purchase. This is how the policy is supposed to work its way into the real economy. As Draghi explained: ‘our asset purchases help us further lower yields across maturities and asset classes by compressing risk premia in the markets where we intervene.’ Unfortunately, higher risk and lower yield is not a winning combination for investors, particularly if they have to hold onto that risk-weighted rate of return over the long term. Financial institutions like banks, insurance companies, and pension funds are all suffering as a consequence. So far, Draghi suggested, that has not proven to be a problem insofar as ‘these positive effects of our measures have not been accompanied by significant distortions that might start to tip the cost-benefit calculus.’ Nevertheless, he conceded that ‘the best way to ensure that remains the case is to go back to our objective soon.’

Therein lies the conundrum. The Governing Council has to wait as long as it takes but that might not be soon enough. Alas there is no easy way out of this situation. The reason, Draghi conceded, is that ‘we operate under a framework of monetary dominance’. There is no other source of stimulus on offer. Moreover, ‘there are always side effects to monetary policy. And we are not at liberty to choose to fail our mandate.’ The member state governments of the euro area could help tip the balance for the ECB in the race between monetary stimulus and market distortions. They could ‘strive for a more growth-friendly composition of fiscal policies’, for example. And ‘if structural reforms are in place, the time it takes to reach [the ECB’s price stability] objective is shorter.’ But neither supportive fiscal measures or sweeping structural reforms are likely to materialize quickly. The conclusion this leads to is fatalistic: ‘for interest rates to be higher tomorrow, they have to be low today.’

This synthesis of Draghi’s comments is important. Despite his protests that the ECB retains room for maneuver and will respond if necessary to any adverse shock, the language of the press conference and the speech shows just how close the Governing Council is to the limits of its capacity to steer the euro area economy. That is not cause for hand-wringing. Provided nothing too terrible happens, the euro area economy should continue to recover. That recovery may even gain momentum. But the best-case scenario is still much diminished from the expectations of previous generations. Europe’s politicians need to start thinking outside the ‘framework of monetary dominance’ because Europeans may not be willing to wait as long as it takes for Europe’s economic performance to move beyond ‘recovery’ to something better.

This essay was originally published by MNI Euro Insight. The edited version can be found here.