28 March 2012

Tornell/Westermann: Has the ECB hit a limit?

"Should the inflation outlook worsen, we would immediately take preventive steps". So said Mario Draghi, President of the European Central Bank. This column argues that these are brave words given that the ECB has hit a limit in its ability to prevent an acceleration of inflation.

In December, the ECB successfully forestalled a financial crisis by stepping in with a big bazooka and inundating the market with liquidity. Unfortunately, the big bazooka has come at a cost; the composition of the ECB’s balance sheet has changed dramatically.

Under standard monetary policy, when there is a sudden increase in money growth, the central bank can increase its short-term interest rate and thereby reduce its short-term loans to banks. This policy causes a reduction of bank lending to households and firms, which absorbs excess liquidity and prevents an acceleration of inflation. The ECB has lost its ability to implement this type of anti-inflationary policy.

In principle, the ECB could take other actions to absorb an excessive increase in liquidity. It could:

• increase minimum reserve requirements;
• sell assets other than its short-term loans to banks; or
• increase the interest rate on bank deposits at the ECB to discourage banks from making withdrawals.

Let us consider each in turn.

Is the ECB likely to increase the minimum reserve requirements in the foreseeable future? The short answer is no. In fact – as part of the big bazooka – the ECB reduced the minimum reserve ratio from 2 per cent to 1 per cent on 8 December 2011. As a result, minimum reserves fell by a remarkable €104 billion in February 2012. In the next few years, the ECB will find it exceptionally difficult to increase minimum reserve requirements because there is a sharp asymmetry ofexcess deposits across countries. While in some countries the excess of deposits over minimum reserves is quite high (e.g. €313 billion in Germany), in other countries there are practically no excess deposits (e.g. €1.5 billion in Italy). Therefore, if the ECB were to increase minimum reserves, there might be systemic bank failures among these low excess-deposit countries. Since the ECB cannot discriminate by increasing minimum reserves for some countries while not for other countries, it will likely keep minimum reserves at low enough levels so that none of the countries risks a liquidity squeeze.

Could the ECB instead sell other assets in its balance sheet to mop up liquidity? ...It will not be easy for the ECB to do so.... Clearly, the ECB has hit a critical limit.

The third option, increasing ECB interest rates on bank deposits sufficiently to stem an exodus of withdrawals, does not seem realistic. In fact, excess deposits are typically zero in normal times. Moreover, high enough interest rates on deposits – without a higher lending rate – might generate losses at the ECB, which is a politically sensitive issue.

In summary,... the ECB has lost its ability to implement standard anti-inflationary policies. It is in this sense that Draghi’s statement is brave.

The fact that the ECB has hit a limit does not mean that inflation will flare up soon. It does, however, mean that the ECB’s space to manoeuvre has become narrow. This lack of manoeuvring space will induce an inflationary bias in monetary policy: At the margin, the ECB will find it costlier to hit the anti-inflationary brakes than to push the monetary accelerator. This bias puts the eurozone at risk of de-anchoring long-run inflationary expectations. The danger is not inflation today, but the de-anchoring of expectations about future inflation. 

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