ECB Hands Down Disappointing Result

April 2, 2009

The ECB cut its three key rates by 25 basis points.  The main refinancing rate becomes 1.25% instead of the 1.0% that markets were discounting.  The decision was “measured,” meaning a guarded consensus and not unanimous.  The released statement of the Bank’s 22-person governing council made no mention of plans to buy corporate bonds or to undertake any other forms of quantitative easing in the future.  And whereas March’s statement said growth risks “now appear to be more balanced,” today’s sends a more emphatic message that “risks to this outlook for economic activity are broadly balanced.”  The statement doesn’t deny that a “severe” world and regional downturn continues or that contraction will occupy just about all of this year, but it contends that a gradual recovery will begin in 2010.  Inflation is depicted as subdued, volatile with the possibility of some sub-zero readings but only temporarily.  For the all important medium-term projection of inflation, officials rely for guidance on signs of well-anchored expected inflation consistent with the target of below-but-close-to-2%.  That evidence is the mainstay of the council’s conclusion that policy is not too tight.

Elements within the governing council undoubtedly balked at the prospect of a zero deposit rate, which instead was cut only to 0.25%, or at narrowing the corridor between the deposit and marginal lending rates, which could have permitted a positive zero rate with a refinancing rate of 1%.  But they gave no reason why more aggressive action was not adopted in the face of subdued inflation, more broadly based declines in pricing pressure, very subdued lending to corporations, and other evidence from their monetary cross-checking analysis, which confirmed that inflationary pressure is diminishing.

ECB policy is biased.  The same vigilance shown against a rise of inflation is not displayed against disinflation or a risk of deflation.  Officials feign impartiality in the face of both extremes by resorting to the device of expected inflation, which is a subjective concept and useful for justifying any action.  The policy bias of the ECB can be demonstrated beyond a reasonable doubt.  CPI inflation averaged 3.5% during the first half of 2008 when the refinancing rate was 4.0%.  The price-adjusted rate was thus 4.0% minus 3.5% or 0.5%.  Inflation peaked last July at 4.0%, which set against a 4.25% peak refinancing rate put the real inflation-adjusted policy rate at 0.25%.  Since then, unemployment has climbed from 7.4% to 8.5%.  Real GDP dropped by 1.0% at a seasonally adjusted annual rate (saar) in both the second and third quarters of 2008, then plunged 5.7% saar in the final quarter and by a similar amount this past quarter.  Industrial production and orders tumbled by 21.8% saar and 54.4% saar last quarter.  Exports fell 24% in the year to January.  PMI and confidence indicators point to extremely depressed growth in 2009, implying a dangerously wide deficiency of aggregate demand relative to supply.  The OECD projects a small decline of GDP in 2010 on top a 4.1% plunge this year.  Surely, this backdrop calls for lower inflation-adjusted central bank rates than prevailed last year.  Instead, the 1.25% refinancing rate is 0.65 percentage points above the 0.6% on-year rise of inflation. With CPI inflation at 0.6% and headed lower, ECB officials should be employing as much counter-force as they would if inflation were at 3.0% and climbing, but haven’t done so.  3.0% and 0.6% are equidistant from the 1.8% target.

The weakness of democracy is that decision-making is done by committee.  At 22 people, the ECB Governing Council is far too unwieldy, twice the size of the FOMC, which itself is large by the standard of many other monetary policymaking bodies.  Superimpose this institutional shortcoming on the Bundesbank’s ideological phobia against hyperinflation but blind spot to deflation, and it’s disappointing but almost predictable that the ECB would move too cautiously in the present situation.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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