The negative German reaction to potential unconventional measures at the ECB

Yesterday and today, the German newspaper Frankfurter Allgemeine Zeitung had interesting articles on the ECB’s dilemma from a German perspective. I want to use these as a jumping off point for a discussion about Europe. The question is how much leeway will the Germans give the ECB to ease monetary policy now that recovery has solidified somewhat and inflation is receding.

In the past, I have said that I see all of the major currency areas following a tighter fiscal, looser monetary paradigm to different degrees. Japan is the loosest on this spectrum and the ECB is the tightest, with the Fed in the US, the only central bank now tightening. But in all cases – and this includes the Canadians and the Australians – the paradigm is one that sees monetary policy as the key cyclical policy lever.

As such, the question in Europe now is whether the ECB should loosen policy more in order to ward off deflation and make sure the recovery sticks. In mid-May, I outlined five initiatives the ECB could undertake to loosen policy. And my conclusion at that time was that the ECB would become more activist because the data gave them a green light for activist policy. The only question was: how activist; are we talking unconventional monetary policy tools here?

Yesterday’s cross-post from Vox on repairing the transmission of monetary policy through asset-backed securitisation was a good outline of one of the more unconventional policy tools the ECB could use. While I think this is a possibility, I am not convinced the ECB is there yet. And the read from the FAZ will demonstrate why.

Former ECB chief economist Juergen Stark wrote a long guest post in the FAZ on Tuesday that must be viewed as public appeal to counter any desire by the ECB to get unconventional (German text here). Stark sees absolutely no reason for loosening policy at all.

Here’s what he said (half translation/half paraphrase):

• The market now believes that Mario Draghi has hinted strongly that the ECB will present a package of additional easing measures on 5 June including at least a further cut in rates that would lead to a negative deposit rate.
• Other measures the market thinks are up for grabs are longer-term-liquidity operations like the British Funding for Lending scheme. And eventually, even QE is thought possible.
• However, the Lisbon Treaty precludes political interference in monetary matters. And the fact that we are even discussing these measures tells you the euro crisis is not over. Weak economic growth, high unemployment, high levels of private and public debt , banking problems in the periphery and reform fatigue and complacency tell you so as well.
• What is the ECB focussing on? Lending, the euro exchange rate and the risk of deflation. Lending in some countries is the crucial aspect here because, while large companies can get credit via the capital markets, SMEs in peripheral countries need to get loans. And they are having problems there.
• But the reason credit is not available is because the peripheral banks have so much bad debt on their books already. The balance sheet exercise that the ECB is conducting will do great things in identifying problems that need to fixed.
• On the securitization of loans to medium-sized companies and the purchase of asset-backed securities by the ECB, is that even a task of the central bank? “It is not the task of a central bank to promote a specific financial instrument or market segment and thereby subsidize loans for a specific group of companies in some economies.” If this is a serious economic policy problem, then it is up to governments to tackle this. This could be done together with the European Investment Bank , in cooperation with national development banks, but not via the ECB. Moreover, no investment decision is going to depend on a minute change in interest rates.
• So far, only smaller central banks have experience with a negative deposit rate, and their experience is very mixed. However, these central banks pursued because of their currency peg to the euro [READ: Denmark].
• This is also true for ” funding for lending” . Its effectiveness is according to the experience of the British central bank also ambiguous.
• The ECB president rightly and repeatedly stressed that the ECB does not pursue an exchange rate target . The exchange rate is only relevant for monetary policy if it has a significant impact on prices and there is currently no risk of deflation. The current inflation rate of 0.7 percent in the euro area means price stability. Thus, the ECB fulfills its mandate. All other interpretations are misleading. The ECB should ” look through ” by the low inflation. President Draghi himself has repeatedly pointed out that there are no negative expectations from private households or businesses that would result in a postponement of purchase or investment decisions.
• Any monetary intervention distorts the market and leads to redistribution of risks and prosperity.

This is a fair and complete summary of Stark’s remarks and I believe his view is shared by Bundesbank head Jens Weidmann. Moreover, I also believe that Draghi wants Weidmann onside. Therefore, to the degree he gets Weidmann onside, given Stark’s remarks, it is clear Draghi will have to soft peddle change. A token rate reduction and one other measure are probably all we can see even if Weidmann dissents. Nothing in Stark’s commentary gives an inch on reducing rates, let alone conducting unconventional monetary policy. It will be difficult to go very far into the unconventional zone with that backdrop.

For now, near zero rates are about all the ECB is prepared to do. They will probably do one other move tomorrow. But even that move is questionable given the vehemence of German opposition. If we don’t see any additional measures, expect asset prices to react negatively.