As it stands, the headline consumer price index in the euro zone hovers around zero, and even core inflation remains below one per cent - too far for comfort from the ECB's target of around two per cent. While a new round of weakness in global commodity prices earlier this year contributed to these figures, it does not explain the weakness in longer-term inflation expectations, which have improved little since March, when the ECB started its massive Euro 60 billion ($66.3 billion) per month bond-buying program.
But instead of rethinking its strategy, the ECB is considering doubling down: buying even more bonds and lowering its benchmark interest rate even further into negative territory. This would be a serious mistake.
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Easier credit conditions and lower interest rates are supposed to boost growth by stimulating investment and consumption demand. But in the core of the euro zone - countries like Germany and the Netherlands - credit has been plentiful, and interest rates have been close to zero for some time, so there was never much chance that bond purchases would have a significant impact there. And, indeed, the European Commission's most recent economic forecast shows that spending in the core countries has not increased as a result of the ECB's policies; Germany's external surplus is actually increasing.
Of course, in the highly indebted peripheral countries, there was room for interest rates to fall and for credit supply to grow - and they have, leading governments and households to increase their spending. While the asymmetrical impact of the ECB's policy is appropriate in principle (because unemployment is much higher in the periphery), the reality is that a recovery supported by the least solvent economies is not sustainable.
Back in 1986, Hyman Minsky warned about the longer-term dangers to financial stability if "Ponzi" borrowers - those who can service their debt only with new debt - become the main pillar of the economy. A zero-interest-rate environment is of course ideal for such borrowers, because there is nothing to provide an indication of solvency; borrowers can just roll over their debt. But it is bad for those with a strong asset position; by reducing their spending power, it spurs them to save even more.
The standard response to Minsky's concern - that the spenders can't afford it and the savers aren't spending - is that monetary policy should focus on ensuring price stability, while the macroprudential policy aims to safeguard financial stability by limiting borrowing by highly indebted agents. But this approach does not work. If macroprudential policy limited additional credit to marginal borrowers effectively, monetary policy would have no impact on demand (as long as the most solvent agents refuse to spend more).
This problem arose in the United States after the 2001 recession. Although the Federal Reserve kept interest rates low for a protracted period, the corporate sector did not increase its investment. The recovery was ultimately fueled by so-called "subprime" mortgages: home-purchase loans extended to borrowers with lower credit ratings. The result, as we know, was a mega-bubble that triggered the 2008 financial crisis.
In the euro zone's case, the risk is compounded by the ineffectiveness of its key macroprudential instrument, the Stability and Growth Pact, in limiting countries' spending, as lower interest rates give debtor countries leeway to spend more. Public debt as a share of GDP is on the rise in Italy and Spain, even though both countries, with their euro zone partners, have committed to reducing the debt ratio. In fact, even without lower interest rates, the deficit limits that the pact imposes have proved to be non-binding, exemplified by France's flouting of them since 2009.
In short, monetary policy is perpetuating the disequilibrium between creditor and debtor economies in the euro zone, and macroprudential policy is doing nothing to stop it. When interest rates normalise, this could generate serious financial instability. But - and this is the conundrum - the ECB has few options for stimulating demand among the euro zone's more solvent agents, and thus supporting a sustainable recovery.
In deciding its next move - whether to initiate more bond purchases, lower interest rates even further, or do both - the ECB must recognise that any positive impact on demand probably will be limited to the euro zone's weaker economies - that is, the economies that can least afford it. This is a high-risk move, one that is probably not justified by the effort to bring price increases a few dozen basis points closer to the ECB's target.
A recovery has already begun in the euro zone. It should be left to run its course. An even more expansionary monetary-policy stance might strengthen the recovery marginally, but at the cost of increasing the euro zone's already-dangerous imbalances.
© Project Syndicate