As European Central Bank policy makers vaunt the success of their stimulus measures so far, they remain as aware as ever of its limits.
Fresh from their latest policy meeting in Frankfurt, euro-zone officials are now headed for Washington, where the International Monetary Fund singled out the currency bloc in an assessment last week on the depletion of growth potential across the world. The IMF and the ECB concur that decay from two recessions since 2008, one debt crisis and the lack of reforms to repair the damage risk acting as a brake on inflation that monetary stimulus can’t overcome.
“A lower rate of potential growth can turn into a permanent hindrance for monetary policy,” ECB Executive Board member Peter Praet said in e-mailed comments to Bloomberg. “That makes it even more urgent that governments implement necessary structural reforms.”
ECB President Mario Draghi on Wednesday also repeated a call for government reform measures to complement stimulus, even as he claimed “clear evidence” that it’s working. That need for political action to renovate Europe’s rusted economy preoccupies him and colleagues such as Praet, the ECB’s chief economist, who will speak alongside Federal Reserve Vice Chairman Stanley Fischer on an IMF panel on Thursday on the “elusive pursuit of inflation.”
The fund’s forecasts this week underscore the challenge for the ECB. While it raised its growth projection for the euro area, it also predicts almost no price growth this year — a low-inflation environment that is a consequence of the vast amount of slack still left in the economy.
The IMF estimates the euro-area output gap was 2.8 percent in 2014, and won’t be closed — meaning the economy won’t work at full capacity — before 2020 at the earliest. Its analysis showed potential growth in the region, unlike other advanced economies, has barely improved since 2009. At 0.7 percent, it is more than 1 percentage point lower than in the U.S.
After years of calling on the ECB to take the lead of other central banks including the Federal Reserve and implement quantitative easing, the IMF is more supportive and sides with European policy makers’ analysis of economic blind spots.
“Potential growth remains weak — a result of crisis legacies, but also demographics and a slowdown in total factor productivity that predates the crisis,” the IMF said on the euro area in its World Economic Outlook. For all nations, “raising potential output is a priority for policy makers. The reforms needed to achieve this objective vary across countries.”
The ECB estimates that inflation will average 1.8 percent in 2017, effectively at its goal of just under 2 percent, so long as its 1.1 trillion-euro ($1.2 trillion) QE program is implemented in full. The central bank’s quarterly Survey of Professional Forecasters published on Thursday showed analysts foresee the rate at 1.6 percent in 2017 and 1.8 percent in the long term.
Still, policy makers are less than certain that bond-buying can sustain a pickup in inflation and growth after it ends in September 2016. Praet’s concern is that lower real income prospects discourage spending and investment, which can in turn add to downward pressure on prices.
“In Europe, we face a situation of very low inflation,” ECB Vice President Vitor Constancio said in Washington. While a moderate economic recovery is underway, monetary policy needs to remain accommodative amid low potential growth, he said.
In the U.S., where the Fed’s preferred gauge of price growth has been below its 2 percent target for almost three years, policy makers worry about “inflation persistence,” a condition where prices are slow to move from prevailing levels, thus threatening to weaken confidence in the central bank’s ability to meet its goals.
While Minneapolis Fed President Narayana Kocherlakota has said there’s “enormous uncertainty” of hitting the inflation target by 2018, his Richmond colleague Jeffrey Lacker sees a “strong case” for raising interest rates this year as the U.S. economy improves.
“Have central banks really got the tools they need to achieve growth and inflation targets sustainably?” said Mark Schofield, director of global strategy at Citigroup Inc. “The reality may be that interest-rate policy is simply no longer up to the job of boosting growth and achieving steady inflation targets when fiscal policy in so many major economies is clearly broken.”
In Japan, the strategy to cure its economy from years of deflation combines fiscal stimulus, monetary easing and structural reforms, a policy dubbed Abenomics after Prime Minister Shinzo Abe.
Draghi is after a similar mix. He has urged governments to reduce debt, focus on a growth-friendly composition of fiscal policy and implement reforms to improve the environment in which companies do business. His calls have intensified since the ECB started QE.
“Monetary policy as such cannot have a long-lasting effect whereby potential output growth increases,” he said on Wednesday. “That’s why the combination of monetary policy and structural reforms is so important. Because what gives to the economy the resilience to carry on the recovery through time is structural reforms.”
Draghi’s push isn’t selfless. Lower growth potential leaves the ECB with less scope to use interest rates — and a greater need to rely on more controversial policy instruments, according to Praet.
It “can reduce the policy interest rate which is sustainable in the long term,” said Praet. “Therefore, the central bank may have -– under those circumstances — to reduce the policy rate to zero or even below more frequently.”