A Reputation as a Rate Cutter
When Mario Draghi took charge as President of the ECB in November 2011, the EZ was at the high point of the sovereign debt crisis, which then resulted in the 2012-13 recession. Former President Jean-Claude Trichet had hiked the ECB’s key rates twice that year and the main refinancing operation rate was 2.25%. Draghi decided to reverse those hikes in his first two meetings and follow those up with another six cuts, which pushed the deposit rate into negative territory starting in June 2014. Draghi also delved into unconventional monetary policy by introducing the large-scale Asset Purchase Program (APP) to stimulate the EZ economy. However, he will be most remembered for his way of recognizing and managing markets’ expectations with his famous “whatever it takes” quote in July 2012.
Growth Supporting ECB Policies
The loose monetary policy conditions, together with the pickup in activity of the EZ’s main partners, helped the economy to recover and expand by 10% over the past eight years. This resulted in the creation of more than nine million jobs and the reduction of unemployment by more than 3.5 million, which brought the jobless rate to just above the pre-crisis low despite a rise in the participation rate. Coupled with rising domestic savings, the stronger economic activity has brought the current account from a balanced position to a surplus of around 3% of GDP.
However, the ECB’s mandate is to deliver price stability, which the Bank defines as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term.” The inflation target was then refined in 2003 as “below but close to 2%.” Headline inflation averaged 1.2% over the course of Draghi’s term, well below both the target and the average of the previous eight years of 2.1%. However, it is important to consider the 2011-13 sovereign debt crisis, the unsupportive fiscal policy that slowed a recovery—with the primary budget deficit falling from 3.4% of GDP in 2010 to zero by 2014 and into an over 1% of GDP surplus since 2017—and the sharp fall of energy prices that added deflationary pressures in 2014-16. Therefore, although EZ inflation has failed to reach the ECB’s target and price pressures remain subdued, much to the puzzlement of economists, there are attenuating factors that must be taken into account.
Faced with deflation risks, the ECB decided to enter the uncharted territory of unconventional monetary policy by cutting rates below zero and purchasing over €2.5 trillion of assets (nearly 22% of GDP) in the past five years. These policies helped slash bond yields, with the German government borrowing at negative rates for any maturity and the Italian BTP yield compressing by nearly 88% from a high of over 7% in November 2011 to just under 1% in recent weeks. Unconventional policies have also pushed property prices and equity markets higher, with the Stoxx Europe 600 rising by two-thirds since November 2011 as investors have chased yields away from public sector bonds.
Inflated asset prices are among the side-effects of unconventional monetary policies, together with possible increases in income inequality, which itself comes from the rise in asset prices but is mitigated by job creation and the creation of dis-incentives to deleveraging. However, according to a recent paper by the Committee of the Global Financial System, such negative effects are not sufficiently strong to offset the benefits of such policies. There is no counterfactual, but given their inability to consistently generate sufficiently strong inflation, one must ask if there is still logic in implementing these policies and whether there is the risk that the EZ economy and the markets have now become addicted to them.
Lagarde’s Challenge: Coordination, but Not Modern Monetary Theory
The debate on the suitability of negative rates and the APP will continue into Lagarde’s term, given that the President-designate has thus far praised the use of unconventional monetary policies. Her challenge is to enhance the effectiveness of the ECB’s current monetary policy by fostering coordination with fiscal policy. When the two economic policies work together in a coordinated manner, they reinforce each other and achieve the goal of stimulating the economy with more limited side-effects. This is what happened in the U.S., which recovered more quickly from the global financial crisis. The difference is that the U.S. is one country, and hence, coordinating fiscal and monetary policies is much simpler. Lagarde will have to use all her political capital to achieve that coordination throughout the EZ.
However, Lagarde’s political skills and moral suasion most likely will not cross the line that demarks monetary and fiscal policy and that guarantees the independence of the ECB. Implementing the principles of Modern Monetary Theory by monetizing EZ public debt would destroy the credibility that the ECB built in the course of 20 years around its independence. We do not expect Lagarde to try to go down that route, and even if she tries, she would not receive support from the European Council nor the European Parliament.