The European Central Bank has announced new measures to fight surprisingly low inflation and sluggish economic growth throughout the Euro area. While these initiatives, made public last Thursday, will provide some relief, they are, regrettably, poorly designed to affect inflation and may have negative effects on growth as well. They are likely to fall short of accomplishing their goals.
Of the several new initiatives unveiled, the most helpful and certainly the most intriguing involved moving the interest rate paid on funds held by banks on deposit at the ECB into negative territory. By charging, instead of paying, banks for holding reserves, this policy actually works along traditional lines, exactly as described by the textbook model of the monetary system. Specifically, the rate cut makes reserves less attractive and thereby provides banks with the incentive to use their excess funds to make additional loans or purchase other assets with higher yields. As all banks act, in tandem, to lower what textbooks call their "reserve ratios," the supply of funds to the non-bank public expands. Broader measures of the money supply rise, moving inflation higher as well.
Thus, the negative deposit rate will certainly help the ECB strike back against low inflation. This policy initiative is one that the Federal Reserve ought to consider as well. By lowering the interest rate it pays on bank reserves, if not into negative territory at least down to levels below those available on Treasury bills and other safe and highly liquid assets, the Fed could likewise reassert more control over U.S. inflation. The only problem with the ECB's move is its very small size. Will a reduction in the interest rate on reserves from zero percent to minus one-tenth of one percent be enough to bring inflation back to target? I fear that it will not.
The other initiatives announced by the ECB make additional loans available to European banks, conditional on their willingness to make those borrowed funds available as credit to households and businesses. These moves, too, have a beneficial monetary component, since when the ECB lends funds to a bank, those funds take the form of newly-created reserves. When banks turn around and lend the funds out to the non-bank public, broader measures of the money supply rise, again according to the textbook model, and inflation rebounds as well.
The problem is that, ordinarily, when a central bank wishes to increase the supply of reserves to the banking system, it does so not by lending those reserves to banks but by injecting them permanently into the economy through outright open market purchases of government debt. An alternative plan, like the one proposed by my Shadow Open Market Committee colleague Mickey Levy, according to which the ECB would follow the usual approach by vowing to purchase bonds issued by the individual European governments until measures of the money supply begin to show more robust growth, would be far more effective and reliable in moving inflation back to target.
Instead, the ECB's lending programs combine a beneficial monetary effect with a potentially pernicious credit-market effect, since those programs represent a direct attempt by a governmental agency to allocate lending to particular sectors of the economy. Repeatedly, history has shown that when governments interfere with the allocation of scare resources, in markets for credit or any other good, instead of leaving that task to private agents with their own money to gain or lose, they make problems worse not better. Perhaps this case will turn out differently, but again I fear that it will not.
Market reactions to the ECB's announcement were particularly telling. European stock prices moved higher, but the daily moves proved nothing out of the ordinary. In the meantime, the foreign-exchange value of the Euro actually rose--a puzzling effect if one views the ECB's action as a monetary policy easing. In the end, the news was no news. The European Central Bank will have to come back, later this year or next, with bolder and more focused initiatives if it wishes to bring inflation back to target.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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