Lagarde’s deflation dilemma: virus piles stimulus pressure on ECB
The day after Christine Lagarde presents the European Central Bank’s latest monetary policy decision on Thursday, new figures are expected to show the eurozone sank into its third consecutive month of deflation — something it has done only twice before.
The fear that Europe is becoming bogged down in a Japanese-style cycle of weak growth, negative interest rates and sub-zero inflation is expected to dominate discussions among ECB policymakers this week, even if they are likely to take no immediate action.
The gloomy pricing data on Friday will be accompanied by a rare piece of good news for the eurozone, with gross domestic product figures expected to reveal record growth of close to 10 per cent between the second and third quarters — bouncing back from a deep recession in the first half of this year.
But those numbers already seem out of date, as a resurgence of coronavirus infections and tightening government restrictions — including curfews in France, Italy and Spain — threaten to drag the 19-country bloc into a double-dip recession.
In response to the darkening outlook, Ms Lagarde is expected to signal clearly that more stimulus is likely in December.
The challenge for the ECB president is that, with the eurozone sliding towards another downturn and governments still bickering over the details of the EU’s €750bn recovery fund, doubts are rising over the central bank’s ability to pull the economy out of the slump.
“The problem is, the fourth quarter looks like being a disaster,” said Lucrezia Reichlin, an economics professor at the London Business School and former head of research at the ECB. “We need to avoid the mistakes of Japan and that means doing more on both fiscal and monetary policy in a concerted way.”
Although monetary policy “has a very clear effect on reducing the spread [the gap in lending rates between riskier and safer borrowers]”, Ms Reichlin warned that “there is a big question mark over how much that translates into higher inflation”.
When Ms Lagarde was appointed to replace Mario Draghi as ECB president almost exactly a year ago, many commentators believed that her Italian predecessor had used up most of the ammunition in the central bank’s stimulus armoury. But since then the ECB has come up with several new ways of injecting cheap money into the economy.
First, it launched a €1.35tn emergency bond-buying programme that dispensed with the self-imposed limits that threatened to restrict asset purchases. Second, it agreed to accept bonds as collateral even if they were downgraded below investment grade status after the pandemic started. And finally, it started lending money to banks at rates as low as minus 1 per cent — the first central bank to lend below the rate it pays on deposits.
These measures — along with a massive fiscal stimulus launched by eurozone governments — have been widely credited with preventing the pandemic from triggering another debt crisis in the bloc.
However, the ECB’s main objective is to achieve price stability, which it defines as inflation of close to but below 2 per cent. It has failed to hit this target for years, despite buying trillions of euros in bonds and cutting interest rates deep into negative territory. Now economists warn that it seems further away than ever before.
The ECB is stuck in a “lowflation trap”, according to Athanasios Orphanides, the former head of Cyprus’s central bank who is now an economics professor at the MIT Sloan School of Management. “Since 2012, average inflation has been only 1.1 per cent.”
Others, such as Daniel Harenberg, an economist at Oxford Economics, believe Ms Lagarde is facing “secular stagnation”. Anatoli Annenkov, an economist at Société Générale, said: “Is monetary policy even working at this stage?”
Given the damage that the pandemic’s resurgence is likely to do to swaths of the economy, the ECB has admitted that deflation is likely to last until early next year, when it hopes a reversal of German tax cuts will boost prices.
Such a prolonged period of deflation is unhealthy for an economy because it can discourage consumers from spending and businesses from investing if they believe prices could be lower in future, while it also increases the burden of repayment on debtors in real terms.
Recent surveys of eurozone consumers and businesses have all pointed to a sharp downturn in confidence and activity since coronavirus infections started hitting new highs in many countries this month. Another worrying sign for the ECB is that banks reined in their lending in the third quarter and said they planned to tighten credit standards further in the final months of the year.
The ECB’s forecast of 3.1 per cent GDP growth in the fourth quarter looks increasingly improbable and Ms Lagarde is widely expected to signal that more monetary stimulus is likely unless the outlook improves before its next rate-setting meeting in December.
However, if the central bank is to avoid being trapped in a deflationary spiral, economists say it may need governments to provide even more fiscal stimulus.
“I think there will be a new bazooka from both the European fiscal and monetary sides by the end of the year,” said Ms Reichlin. “They will have to keep on pumping with all that they have.”