Wednesday, March 28, 2012
Having been heralded around the world for solving Europe’s crisis, ECB head Mario Draghi confidently states (as does every other central banker in the world) that “should the inflation outlook worsen, we would immediately take preventive steps”. However, a recent analysis by Tornell and Westermann at VOX suggests the ECB has hit its limit with regard to its anti-inflationary fighting measures. The ECB appears to have lost control over standard measures of tightening: short-term interest rates (since short-term lending to banks has dropped to practically zero), increase in minimum reserve requirements (practically impossible withouit crushing the banks that they have propped up due to the sharp asymmetries – the recent cut from 2% to 1% minimum reserves saw a remarkable EUR104bn drop), and finally asset sales (the quantity of ‘sensitive’ or encumbered assets on the ECB’s books has reached such a scale – due to LTRO, SMP, and ELA programs – leaving the ‘sellable’ non-sensitive assets at a level below excess deposits for the first time in ECB history). As the authors note, while this does not immediately produce an inflation flare, the lack of maneuvering space will induce an inflationary bias to ECB monetary policy as Draghi will find it increasingly expensive at the margin to hit the anti-inflationary brakes. “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.” As we have noted many times before, the ECB (and for that matter most central banks in the world) need Goldilocks.
Standard monetary ‘instruments’ to control inflationary concerns (or the ECB’s ability to absorb an excessive increase in liquidity) have hit a limit:
Short-term interest rates will be ineffective since ECB lending to MFIs is now minimal:
Increasing the minimum reserve requirement will crush banks capital – especially damaging for low-excess deposit countries where systemic bank runs would likely occur:
And finally asset sales is very limited since the unencumbered (or non-sensitive) ECB assets – that are practically saleable – have crossed below the excess deposits level for the first time – standing at just 26% of the balance sheet (simply out the ECB would not have enough non-sensitive assets to sell in order to cover a withdrawal of excess deposits by banks):
In summary, the intersections in Figures 1 and 3 make clear that the ECB has lost its ability to implement standard anti-inflationary policies.
This article was posted: Wednesday, March 28, 2012 at 8:46 am