ECB Shadow Council Discusses What the ECB Should Do On April 2

Members of the ECB Shadow Council discuss how low rates should be cut, which rates are currently the most relevant ones, and what other measures the ECB should employ. Latest entry by José Alzola (bottom of page)

Angel Ubide , Chief Economist of Tudor Investment Corporation in Washington

The ECB should cut rates 100bps to 0.5 percent and make clear that rates will stay low for an extended period of time. The "limit" of the deposit rate is just irrelevant: I would cut the main policy rate to 0.5 percent and collapse the corridor to +-25bps. It is critical that the ECB finalizes the rate cutting process as soon as possible, so that policy uncertainty is removed. Markets badly need to have a clear idea of what the policy stance is. Then, the ECB must clarify its stance on asset purchases once and for all. For as long as the stance is unclear, private money will not take risk in those areas - logically, as the policy risk remains high. I don't have a strong view on this. My personal view is that the ECB should target the areas of the market that are not functioning and think about providing further liquidity assistance. This could take the form of longer term funding as the TALF in the US, rather than asset purchases. The ECB has been leading the way in terms of collateral policies, and could move further at this point. But in order to do this the ECB must first enter in an agreement with the euro area governments about loss mitigation. The ECB should not do it without a clear, ex ante agreement, or it risks losing its independence.

Elga Bartsch, Chief European Economist of Morgan Stanley in London

I am in favor of a 50 bp rate cut in the refi rate and a signal for further monetary policy easing, if needed. Cutting the refi rate to 1% would push the deposit rate to 0%, thus allowing EONIA to drift towards the zero-threshold. Personally, I would oppose a proposal to narrow the corridor between the deposit and the marginal lending rate because that would partly offset the impact of the reduction in the official policy rate on market interest rates, notably on EONIA and EURIBOR. As EONIA is entirely determined by the extent of overbidding by the banking system in the regular refi operations and the reluctance to fund counterparties in the interbank market, the split interest rates are just a side effect of the ECB’s unlimited liquidity provision and as such not a reason for concern. Given that EONIA would be able to gravitate towards zero after the 50 bp cut, I would be reluctant at this stage to support a larger rate reduction.

The most important question is now what alternative policy options the ECB could and should pursue. As an intermediate step we should consider extending the time scale of the refinancing operations to one full year or even beyond. In my mind, refi operations have a number of advantages over outright purchases of financial assets. First, refi operations are easier to reverse than outright purchases. This should help to reduce the risk of an abrupt market reaction to the beginning of the tightening campaign, the risk of feeding new asset price bubbles and the risks of, eventually, having to tolerate higher inflation. Second, a refi operation has considerably lower information requirement in the context of what financial assets to “acquire” on the part of the central bank. In a world of asymmetric information these requirements are crucial to the success of an operation. Acting as a price-setter, the ECB can establish in course of the bidding process of a refi operation how much funding the banking system actually needs over a given period. In addition, the ECB can leave it to the banking system to decide which financial assets banks are willing to hand over. Third, in terms of the financial assets underlying the transaction, refi operations offer more flexibility in terms of the collateral that is being pledged. In an outright operation, the risky assets will have been sold for good to the ESCB at what probably are distressed levels, if current market prices are anything to go by. In a refi operation, the banks can always adjust the collateral pool and, thus, would benefit directly from a recovery in risky assets.

Marco Annunziata, Chief European Economist of Unicredit in London

I would favor a rate cut by 100bp to lower the refi to 0.50%, making it clear that the macroeconomic outlook requires rates to be lowered to the lowest possible level. I think the ECB’s latest strategy of driving market rates towards zero via the deposit rate while slowing the descent of the refi is both confusing and counterproductive, it muddles the communication and undermines the very “reference” value of the refinancing rate. I also strongly believe that this should be followed up with “orthodox” quantitative easing, that is outright asset purchases. A formal announcement could be delayed to the following meeting to allow additional time to iron out procedural details and secure the necessary government backing, but at the April 2 meeting the ECB should already indicate it is considering asset purchases. I am increasingly concerned that the ECB is underestimating the risk of deflation. My team’s inflation forecasts, based on a growth outlook which is very similar to the that of the ECB staff’s point to a sustained decline in core inflation, which will hit zero by end-2010 and may turn negative, reflecting a sustained widening of the output gap after three years of growth well below potential. In this context, I see a significant risk that if a delay in the global recovery denies the expected rebound in energy prices, inflation expectations could become unanchored. I also believe that it is premature to worry about an exit strategy from the easing stance. If anything, I fear that if the ECB ends up underestimating the deflation risk after having grossly underestimated the recession risk, its credibility will be critically undermined, opening the risk of a loss of independence. The ECB has demonstrated at the beginning of the previous tightening cycle its ability to hike rates when needed in the face of pressure from politicians and peers—its actions should be based on, and project, full confidence that it will be able to do so again.

Erik Nielsen, European Chief Economist of Goldman Sachs in London

I recommend a rate cut by 100 bp to 0.5% and a reduction in the deposit rate to zero. As I have argued since last autumn, given the outlook for inflation and growth, there is no serious doubt that the rates instrument needs to be exhausted as so as possible; any delay adds a cost to the economy. The ECB should also announce an intention to keep rates low for an extended period of time; they should extend the unlimited money facility to 12 months maturities, and they should make final preparations for outright asset purchases.

Julian Callow, European Chief Economist of Barclays Capital in London)

I think Quantitative Easing - i.e. printing money - would be fatal for the euro. A large swathe of the European population has always had reservations about the euro anyhow. In the UK the tabloid press is publishing "funny money" articles. I dread to think what this would do to the euro's credibility with the eurozone public. The Fed and BoE and SNB can get away with this - once - because they have not done so before.

Charles Wyplosz, Professor at the Graduate Institute of International Studies in Geneva

I would advocate a 50bp cut on all three rates (deposit, refi and lending). This would be the end of the road, although the ECB can always narrow the band between the refi and the deposit rate. Given this, it matters relatively little whether the interest rate is reduced or not at all. Indeed, a 50bp difference will not change the fact that monetary policy is close to helpless. The next big question is whether the ECB will shift to "unconventional policy", meaning printing money. I don't think that pumping money in a liquidity trap situation will make much of a difference. Lending to the private sector could help if there is evidence of a credit crunch, but I don't see any such evidence. In the end, monetary policy is now essentially out of the picture. The best contribution of the ECB would be to encourage scared or confused governments to carry out expansionary policies. But the ECB still feels the need to repeat that fiscal discipline is important.

Jacques Cailloux, Chief European Economist of Royal Bank of Scotland in London

With limited signs of stabilisation in the global economy and or indeed in the euro area, there are increasing risks that the region could face a protracted period of undesirably low inflation. Nominal GDP will contract this year by the largest amount since 1932 while other nominal variables such as credit and money growth are likely to decline on a year on year basis by the end of the year. With headline inflation likely to dip well below 0 in the summer months, inflation expectations could start declining. The degree of downward nominal wage rigidity in the euro area is not only questionable (with increasing anecdotal evidence of wage cuts in the industrial sector) but also can become a key driver of deflation risks in the medium term should domestic demand fail to recover. Indeed, while downward rigidities lower deflation risks in the short term, they become a deflationary force if recovery fails to materialise: the channel is through higher unemployment as the rise in real wage cost forces corporates to fire en masse. The ECB should recognise the rising risk of deflation in the euro area (even if still low) and respond by cutting rates by 100bps at the April meeting. Rates need to be low and considerations about the level of the deposit rate look superfluous. The overnight rate would fall to a little above zero which would send a signal that the ECB has reached a floor leaving the door open to consider other policy options in coming months.

Jörg Krämer, Chief Economist of Commerzbank in Frankfurt

I prefer a 50 basis point rate cut to 1.0%. According to our deflation vulnerability indicator the deflation risk is currently low for the euro-zone. However, if our -4.5% GDP forecast for 2009 turns out to be correct, the deflation risk will go up in the coming months. Therefore, I would be ready to take the risk to cut rates to an extremely low level to mitigate the risk of deflation. Nevertheless, it is important to quickly unwind the monetary stimulus once the deflation risk declines again.

Stepehn King, Chief Economist of HSBC in London

In my view, a 50 bp rate cut looks like a delaying tactic. By doing so, it simply puts off the date at which the ECB has to declare its hand on alternative monetary policies. A 50 bp cut would leave the ECB - and us, for that matter - discussing next month whether or not there should be a further 50 bp cut rather than focusing on the important "next steps" which will ultimately matter for the economy and financial markets. Monetary policy works through a number of different channels but one of the most important is through its influence on expectations. Delaying tactics are counterproductive and leave the markets guessing what the central bank is planning to do. Guesswork is no way to encourage a return of financial confidence. Admittedly, quantitative easing still leaves people guessing but that's a second order problem. The primary question at this stage is whether the ECB is prepared to offer anything meaningful beyond rate cuts: that question, unfortunately, remains unanswered.

Christian Bordes, Paris 1 University – Centre d’économie de la Sorbonne

In the current situation, characterized by very low policy rates and a weak real economy, an analysis of inflation expectations is crucial: is there a risk of a deflationary spiral starting in the Euro zone, the real interest rate being too high while the nominal interest rate would be near zero and the growth rate negative? From a look at the break-even points (as measured on the swaps market at the end of last week) the following path emerges for the Euro zone inflation rate in the future: 1. a low, but positive value (1.22% ; 1.44% ) for the short/medium term (2y ; 3y ) ; 2. a higher value, but still under the 2% target (1.61% ; 1.56%) for the medium/long term (4y ; 5y). This is consistent with a scenario where the public believes that inflation will start from a low position in 2009/10 before returning to the target of 2%, which implies that current average inflation expectations for the longer term are still too low. How can the ECB counter the recession by lowering the real interest rate further ? At the next meeting, the ECB should lower the policy rate by 50bp, which will, de facto, bring the nominal rate on the money market to the zero floor. Then, if the situation does not improve, the only mean for the ECB to stimulate the real economy will be to create higher inflation expectations. For such a purpose, quantitative easing – i.e., the purchases of public or private bonds – would be effective if, and only if, it were permanent ; however, the ECB cannot credibly commit to such a program. Therefore, alternative measures must be considered to move the inflation rate near the medium/long term 2% target. By comparing the breakevens for the US and the Euro zone, it appears that markets expect a lower inflation rate for the first economy in the short term, but a higher one for the medium term. Therefore, in order to raise expectations of the future price level in the Euro zone for the long term, the best solution seems for the ECB to announce that it will, if not keep the EUR/USD exchange rate constant, at least watch/stabilise its level (of course, the impact of such an announce on inflation expectations would be reinforced if it were supported by the Fed).

Thomas Mayer, European Chief Economist of Deutsche Bank in London

There has been no change to the better since the last meeting, when I favoured a 50bp cut every month until economic developments improve or we reach the zero line. With the suggested cuts, the deposit rate would be at zero, and I would envisage the other rates to follow in subsequent months until they are also at zero. The question of outright purchases of private and public sector debt remains a thorny one. Under present institutional settings I could see national central banks of the ESCB buying commercial paper and / or trade bills, funded by money issuance. Wthout more cooperation with fiscal authorities I would find puchases of longer-dated private sector debt and government bonds difficult. Ideally, national central banks should receive a fiscal indemnity for the purchase of more risky private debt, with national authorities coordinating such a move. Moreover, there should be better coordination of national fiscal policies before the ECB engages in the purchase of government debt (as I believe good cooperation between monetary and fiscal policy is necessary to make this work). Since neither of these conditions are fulfilled I doubt that these options are available for the ECB. This is regrettable as i think that both measures - purchase of more risky private and public debt - would be helpful in present circumstances.

Agnès Bénassy, Director of CEPII in Paris

My impression is that, from now, cutting rates bu 50 or 100 bp does not make much difference since in both cases, the EONIA will be close to zero. Then, my suggestion would be to cut only by 50 bp, I also have the impression that the risk of deflation is under-estimated. Not only is there anecdotal evidence of wage cuts in the industry; but also, there is a high probability that the dollar will depreciate in the coming months, although such things are especialy difficult to forecast. So, I would be in favour of some communication by the ECB that it is seriously considering quantitative easing. But the ECB should also make clear that it is engaging some discussions with governments about risk taking and exit strategies. I don't think it is too early to discuss exit strategies. On the contrary, I think governments need to provide markets and central banks with credible signals on how they will proceed to fiscal rebalancing once growth rates are back to positive territory. They should also offer a scheme for the ECB to be able to shrink its balance sheet when needed, whatever market losses. Without such contingent rules, there is a risk that quantitative easing has counter-productive impact on long-run interest rates.

José Alzola, Senior Economist of The Observatory Group

Business sentiment indicators seem to be stabilizing but at a very low level, indicating the risk that the economy remains stuck at a low level of activity. At the same time, core inflation is slowing clearly (the six-month annualized rate has fallen to 1.25%), providing more marging for an easier policy stance As. there are signs of stabilization (or at least things not getting worse) in the euro area and global economies, a cut by 50 basis points should do for now. At this stage, I do not believe that QE is necessary, because underlying inflation and long-term inflation expectations remain at clearly positive levels but it may be appropriate in future months if an economic recovery fails to emerge because, in that case, the risk of very low inflation would increase. At the same time, there are not yet signs of a broad-based credit crunch but some countries may be suffering from it, and there is a risk of a broadening of that situation.

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