ECB Shadow Council: How Should the ECB react to the financial market turmoil?

Members of the ECB Shadow Council discuss the options for the next policy meeting of the ECB Governing Council on September 4.. Latest comment by:   Giancarlo Corsetti (at bottom of page)

Erik Nielsen (Chief European Economist, Golman Sachs, London)

The best way for the ECB to react is "more of the same": pretty liberal liquidity provision, and the more coordinated, the better. If needed, they should make clear that the amount of liquidity available is virtually unlimited. If asked for a coordinated rate cut, I would decline on present information.

Charles Wyplosz (Director, Graduate Institute of International Studies, Geneva)

The fall in oil prices is good news for both inflation and growth, a present of the sky after much punishment! I also think that the financial crisis is now entering the resolution mode, although banks may be forced to acknowledge losses faster than they wish to, which could harden credit conditions. If this happened, I would have a bias toward cutting the interest rate, but not this month.

Jacques Cailloux (Chief European Economist, Royal Bank of Scotland, London)

The ECB has been the most vocal central bank since the crisis started stressing the need to distinguish the monetary policy setting from liquidity provision measures. The ECB’s action in the last few months has demonstrated how determined it is to stick to that principle. To date the ECB has claimed that the response to the financial crisis required specific tools and that the interest rate tool was not part of them. With significant risks of feed-back effects from the financial crisis to the real economy, even post US bail-out, that separation could become increasingly untenable and the ECB should start recognising that. In the current context, the ECB should relax its rhetoric and send a signal that given the sharp decline in commodity prices, renewed deterioration in the economic outlook could be accompanied by an ease in the policy rate. An easy way of expressing that view would be to include in growth as a downside risk to medium term inflation.

Gernot Nerb (Head of Department, ifo Institute, Munich)

Current inflation is according to all experience a lagging indicator. With the ongoing fall in prices for oil and other raw material prices in combination with the unfolding cyclical downturn in the euro area inflation will probably fall below 3% (y-o-y) already in November and “below, but close to 2%” in the course of 2009. The ECB has to apply a forward looking strategy to avoid being behind the curve. Such a strategy was rightly applied at the beginning of the first easing cycle in May 2001 when the ECB decided to start cutting rates despite a similar level of inflation as now. The actual inflation rate should not prevent from cutting rates when other indicators suggest a clear reduction of inflation in the future.

Thomas Mayer (Chief European Economist, Deutsche Bank, London)

The ECB should keep injecting liquidity, cut interest rates, and pray that the US Treasury’s $700bn Superfund will stop the market melt-down. The financial crisis induced a massive destruction of liquidity in the world financial system. To compensate for the de-hydration, demand for central bank liquidity and liquid government bonds sky-rocket. At least since the Lehman default, money markets experienced a liquidity trap. To counter the financial melt-down, liquidity injection by the central banks is hopefully soon supplemented by an injection of liquidity by the US Treasury’s $700bn Superfund in the RMBS (and other frozen ABS) markets. If things work out as planned, the system has now a chance to heal. The ECB’s worries about “excess liquidity” are misplaced. The opposite is the case. Deflationary forces dominate, and the oil price related inflation increase is a transitory event that should not detract from the main threat. Moreover, the ECB’s recent policy of raising rates and injecting liquidity is inherently inconsistent. Liquidity is needed for the system to come back to life. Lower interest rates are needed for the system to heal. Only if they are allowed to earn money through an upward sloping yield curve can banks replace lost capital and de-lever. Injecting liquidity and keeping rates high is like driving with one foot on the accelerator and another foot on the brake.

Julian Callow (Chief European Economist, Barclays Capital, London)

When there is so much turmoil and policy activisim emanating from the US, it is tempting to argue that the ECB should stand pat while it takes stock of the situation - it seems all the more important amid the current crisis that there are some fixed points in the compass. For example, it is currently very hard to gauge just how the various forces will play off against each other: lower commodity prices should be a boost to confidence; the equity volatility a negative, and we still do not have a very clear idea of how far the process of credit tightening will go in affecting economic activity. That said, as equity markets have discerned on Friday, the decision by the US both to set up a "RTC"-style vehicle to purchase distressed assets, and the guarantee of money market mutual funds, are both highly positive developments that could well offset some of the considerable headwinds.When the dust finally settles, I do think that we shall find that euro area inflation has by the middle of next year got back to around 2%, but with euro area unemployment on a steadily increasing track. Therefore, with the current ECB stance midly restrictive, in my view, I envisage that a case for some easing will materialise. However, it seems that there is still a lot of price pressure in the production pipeline that could spillover, and also there are signs still of rising wage inflation, so I do not think we are quite there yet.

Michael Hume

Over recent years, in common with most other major central banks, the ECB had been concerned about global imbalances and an under-appreciation risk. It identified a disorderly correction as the main downside risk to medium-term growth prospects. Recent events could not have demonstrated more clearly that those risks of a disorderly correction have materialised and it is surprising how reticent the ECB and many commentators are to accept this reality. The prospect for global and euro-area growth is not for a mild slowdown followed by a return to trend growth but one of very low growth, if not contraction, for the foreseeable future. The implications for inflation may not be straightforward but such a prognosis for growth does not appear consistent in any way with inflationary pressures being sustained beyond the short-term boost that has been induced by a commodity price boom that itself is fuelled by the hangover of liquidity attempting to find a new home. While it was understandable that the ECB should be cautious in the early stages of this crisis, such a position is no longer tenable and it should immediately lower interest rates to help put the economy on a path that will gradually take it away from the current financial and economic mess it is now in.

Marie Diron (Senior Economist, Oxford Economics, London)

The ECB’s response to the financial crisis has been appropriate so far. In particular, the central bank has proven ready to inject very large amounts of liquidity very quickly to support financial markets. This support should continue. But there is now a need to be more open about the implications of the financial turmoil for the economy as a whole and to act accordingly. Even if the situation in financial markets were to stabilize today (a prospect which seems unlikely) the ripple effects of the past developments the real economy would be felt for some quarters to come. GDP growth will most certainly continue to slide making the possibility of second-round effects very unlikely. Inflation seems therefore likely to start falling, possibly quite quickly. It is now time for the ECB to consider using its interest rate instrument to support the real economy.

Daniel Gros (Director, Centre for European Policy Studies, Bruxelles)

In this acute phase of the global financial crisis it would be tempting to lower rates, but this would probably at most result in a short relief rally.Once financial markets (including the oil price) have settled down it might very well be possible to cut rates quickly since the outlook for inflation might change radically over the next few months. For the moment I would keep the powder dry.

Angel Ubide (Chief Economist, Tudor Investment Corporation, Washington D.C.)

I think the risks to inflation are starting to be on the downside as a result of the softening in commodity prices, the economic slowdown and the recent seizing up of financial markets that have tightened financial conditions significantly again. In this environment, with the financial sector fragile and confidence in money markets vanishing, the risk of a high impact low probability event has risen materially, and policy should stand ready to act preemptively in this regards. If money market conditions do not improve significantly in the next few weeks, I will be voting for a rate cut at the November meeting, and I would favor a very clear and open minded neutral language at this meeting

Giancarlo Corsetti (Professor, European University Institute and University Rome III)

The need today is to intensify liquidity support, and make sure that Europe is ready to handle possible further negative turn in market sentiment. The ECB by itself cannot do this. Possible fiscal implications of policies in support of the market makes it urgent to intensify coordination in the short run, and rethink the European framework of regulation and supervision.

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