ECB - The Moment Of Truth?

From the FT today:

Moment of truth
By Ralph Atkins

Published: May 5 2009 19:51 | Last updated: May 5 2009 19:51

The global financial crisis is making and breaking reputations – of central bankers as well as the big names in private finance.

On Thursday the European Central Bank reaches what could be a defining moment in its 10-year history. With another quarter percentage point cut expected in its main interest rate – from 1.25 to 1 per cent – the ECB will, later than other central banks, have reduced official borrowing costs to what might turn out to be a floor. The big question then is: what next?

When financial market tensions erupted in August 2007, the Frankfurt-based central bank that sets interest rates for 329m Europeans in 16 countries cast off its reputation as a sluggish, timid institution by swiftly announcing large-scale injections of emergency liquidity. By contrast, the US Federal Reserve and Bank of England appeared slow in their response.

But as the crisis turned into a deep economic slowdown, others took up the running. The Fed cut interest rates much earlier and found other ways to help the economy. The Bank of England also performed policy pirouettes.

Jean-Claude Trichet, ECB president, has announced that on Thursday the 22-strong governing council will decide whether it, too, should move further into “non-conventional” policies. On the table are options such as asset purchases, being deployed in the US and elsewhere in a bid to unblock bottlenecks in the financial system – as in the market for corporate debt, for ex­ample, where banks are holding back.

Mr Trichet knows the stakes are high. Eurozone leaders who initially saw the crisis as a problem mainly for the US have been badly caught out. The eurozone will contract by 4 per cent this year – significantly faster than the US – according to European Commission forecasts this week, with a recovery not expected until next year.

Unemployment is rising sharply and eurozone governments fear a summer of social unrest; its policymakers, including Mr Trichet, have been noticeably more reluctant than their US or UK counterparts to talk of the “green shoots” of economic recovery.

A common criticism is that the eurozone governments have been too cautious in expanding public spending and the ECB too timid in seeking new ways of helping a return to growth. “The big risk,” says Erik Nielsen of Goldman Sachs, “is that [the ECB] will sort of say that ‘this is the finale, we have run out of bullets’. I think that would be terrible – because it is not true.”

Will the ECB rise to the challenge? According to one view, it is already too late. The Fed cut interest rates in late 2007. The ECB, however, was distracted by last year’s inflation spurt fuelled by the oil price – and even raised its main policy rate last July. “With hindsight, lowering interest rates at the beginning was the right thing to do because inflation was going to come down and growth would be declining a year later – and monetary policy works with a lag of about a year,” says Charles Wyplosz of Geneva’s Graduate Institute. He accepts, however, that “it was bad luck – it was a close call”.

After the collapse of Lehman Brothers in September last year, the ECB slashed interest rates – but not fast enough for everyone. “They did the usual striptease, one shoe dropping at a time. I would have gone much faster – quickly down to the zero bound and quickly talking about non-conventional measures,” says Professor Wyplosz.

Adding to the eurozone’s woes, the ECB allowed the euro to remain strong and act as a further brake on activity, while the UK benefited from a weakening currency.

Unsurprisingly, that is not how it looks from the Eurotower, the bank’s low-key glass and steel headquarters in Germany’s financial capital. There, they blame the scale of the eurozone’s downturn on the openness of its economy – especially export-dependent Germany, its largest member. A rule of thumb is that the region was hit twice as badly as the US by the slump in global demand triggered by the near collapse of the world’s financial systems that followed the failure of Lehman. Deflation has been seen as a threat in the US but not in the eurozone.

When it comes to comparing policy responses, the ECB believes insufficient account has been taken of “automatic stabilisers” – the natural increase in government spending and fall in revenues caused by an economic slowdown. Add those effects to the discretionary boost in public spending, and Europe is on a par with the US, runs a popular Frankfurt argument.

The ECB also believes more attention should be being paid to steps it has taken to pump unlimited liquidity into the banking system, which it says will make a decisive contribution to eurozone performance in coming months.

Explaining the significance of that policy to sceptical financial markets has been hard. Mr Trichet calls it “enhanced credit support”. Some of his colleagues reach for the even less media-friendly “endogenous credit easing”. Combined with cuts in the main ECB rate, the effects on market interest rates have been significant. Though official rates are still higher in the eurozone, six-month and 12-month rates have fallen lower in the eurozone than in the US. One-year interest rates are of particular significance because they form the basis for many eurozone mortgages.

The firepower being deployed is shown by the massive expansion in the ECB’s balance sheet, reflecting its dramatic increase in lending. Between June 2007 and the end of last month this rose by €600bn to €1,500bn ($1,997bn, £1,337bn) – equal to 16 per cent of eurozone gross domestic product. By comparison, the Fed’s balance sheet has expanded faster but, at just over 14 per cent at the end of last year, still accounted for a smaller share of US GDP.

Still, nobody pretends the ECB is a hot-bed of revolutionaries. Julian Callow of Barclays Capital says it was fortunate at the start of the crisis because it had the policy tools to provide liquidity to a large number of banks, secured against a broad range of assets eligible as collateral. Subsequently, Fed and Bank of England innovations “showed a determination to do something to counter the recession and return the economy to growth. It was a way of saying: ‘We’re doing all we can – nothing is off limits.’ At a time when things were so weak, that was quite a help in itself. We have not really seen anything like that from the ECB.”

One reason has been Frankfurt’s focus on combating inflation – the main task assigned to it under European Union treaties. To outsiders this can appear obsessive. Eurozone inflation is just 0.6 per cent – compared with the bank’s target of an annual rate “below but close” to 2 per cent. In coming months, inflation will almost certainly fall below zero. But the ECB fears that, if it is seen to drop its guard, there will be an outbreak of the kind of discussion taking place in the US about the long-run inflation dangers posed by policy actions. Germany, with its folk memories of hyper-inflation, has issued warnings that today’s excessively loose fiscal and monetary policies will be tomorrow’s regrets.

The ECB also fusses about its independence, which explains why it has all but ruled out buying government debt, arguing that such a step would blur the boundary between fiscal and monetary policy. Paul De Grauwe of Belgium’s Leuven university says its fears are surprising given that the ECB faces not one finance ministry but 16. “It shouldn’t really be afraid of being taken over by the Treasury – that is something an independent central bank in the US or UK could fear ... yet it acts as if buying the smallest government bond will destroy its independence. It is a kind of phobia.”

There is another reason for the ECB’s policy conservatism, he argues – its committee-based decision-making. The governing council comprises the central bank governors of the 16 member states, plus six executive board members. “We have not seen much creativity on the part of the ECB, and this has probably got to do with the fact that the governing council is too big,” says Prof De Grauwe.

For a gathering of central bankers, it is an eclectic bunch. Besides the odd former politician, some – such as Mr Trichet, previously head of the French Treasury – are career technocrats; others come from academia (Lucas Papademos, the vice-president), investment banking (Mario Draghi of Italy) or even, in the case of Athanasios Orphanides of Cyprus, from the US Fed. It includes nine economics professors. The mix almost guarantees tensions when members jostle for space at the cramped round table in the meeting room at the top of the ECB skyscraper.

In recent weeks, the discord has leaked into the public sphere. Council members have argued, for example, over whether 1 per cent is really the lowest possible level for the main interest rate; Mr Trichet has said zero rates are not desirable, but has carefully avoided saying where he sees the floor.

Those familiar with the workings of the council say it functions efficiently under Mr Trichet’s stewardship. The problem is that the issues involved in embarking on “non-conventional steps” are complex, especially given the eurozone’s fragmented capital markets and political system. The region faced “intricate challenges, due to its unique institutional framework”, Lorenzo Bini Smaghi, an ECB executive board member, argued in a speech last week.

But it is also true that under Mr Trichet’s leadership the ECB has sought to act as a source of stability in turbulent economic times, worrying for example about how it will exit from the measures it has taken once the crisis is over. Prof Wyplosz sees “valid trade-offs” between a US approach that could result in its economy escaping the recession earlier but at the cost of inflation and the ECB’s strategy – “very much in the tradition of prudent central banking, which is a very distinguished tradition”.

Thursday's governing council meeting will not be the last word. In June, the ECB will update its economic forecasts – a process that in the past has spurred it into policy action. As the eurozone economic deterioration continues, some economists believe the ECB will come under pressure to escalate its response. The ECB will know that its reputation is on the line.



AFTER UNLIMITED LIQUIDITY: THE ECB’S OPTIONS

European Central Bank action to combat financial market tensions and the economic recession has so far focused on pumping unlimited liquidity into the banking system, but success depends on banks’ willingness to pass on credit to businesses and consumers . The bank’s possible next moves to improve the effectiveness of its actions include:



Buying government bonds

For- This would indicate determination to take bold action and help inject demand into the economy.
Against - The ECB’s biggest objection is that this would blur fiscal policy with monetary policy. Deciding which governments’ bonds to buy would be hard. It would also add to the difficulties of creating an exit strategy.
Likelihood Extremely unlikely.

Buying private sector assets

For- Buying corporate debt, for example, could help ease specific problems in lending markets.
Against - Technical problems could arise in a monetary union of 16 countries. The ECB might fear it was developing an “industrial policy” favouring particular sectors or members. Relevant markets are negligible in some countries. And how would the bank pay for this?
Likelihood Reasonable, but could be small scale.

Pledging to keep policy interest rates low for an extended period

For- A commitment, for instance, to keep rates low for “as long as needed” would send a helpful signal and reduce long-term market interest rates.
Against - Such verbal reassurances would reverse the ECB’s strategy of never “pre-committing” to a particular interest rate path. There is a danger that markets would not believe it.
Likelihood Reasonable.

Further cuts in the main policy rate

For - A quarter-point cut to 1 per cent is all but certain on Thursday, but going lower would inject further stimulus into the economy.
Against - Though Jean-Claude Trichet, the bank’s president, has not specified the lower limit, any new cuts could bring the rate too close to zero – which he has declared forbidden because of the economic distortions the ECB believes it would create.
Likelihood Low at this stage.

Providing unlimited liquidity for longer terms

For - Extending to 12 months the period over which the ECB lends funds to banks at fixed interest rates would fit squarely with current strategy and enable banks to plan with greater certainty.
Against - Would banks pass on the funds to the real economy? Such a move would tie the ECB’s hands by forcing it to keep interest rates low for longer than it might wish.
Likelihood High.

Loosening collateral requirements

For - Relaxing the rules on what assets banks can put up as security, or smoothing out operational difficulties when borrowing from the ECB, would allow them to borrow even larger sums.
Against - It is not clear that a lack of adequate collateral is currently much of a constraint. Looser rules would involve the ECB carrying greater risks.
Likelihood Reasonable.

Foreign exchange intervention

For -Lowering the value of the euro could help boost eurozone exports.
Against - Intervention is considered dangerous and possibly inflationary by central bankers and would risk “beggar-thy-neighbour” responses elsewhere in the world. It would not necessarily boost demand for eurozone products.
Likelihood Extremely unlikely.

Sitting on hands doing nothing

For - Cool insouciance might appear to be a sign of confidence and prudence.
Against - More likely to be seen as an act of negligence, undermining confidence.
Likelihood Not insignificant.