Mario Draghi’s quantitative easing may look like a precise business; the underlying economics are anything but.
Two recent observations by the European Central Bank on output and employment highlight how monetary policy is far from an exact science, underlining the challenge that the institution’s president and his colleagues will face in their two-day meeting starting Wednesday. In evaluating their targeted strategies to boost the euro area’s feeble inflation rate, they have to measure the economy — and that’s the trouble.
It starts with a paper published on July 1 by researchers Marek Jarocinski and Michele Lenza on the size of the 19-nation currency bloc’s “output gap” — or the spare capacity in the economy. The conclusion that the gap could be as much as minus 6 percent of potential gross domestic product, compared with typical estimates closer to 2 percent, suggests that even the 80 billion euros ($88 billion) a month the ECB spends on stimulus isn’t nearly enough.
Source: ECB, Jarocinski & Lenza 2016
“If you really believe that the output gap is minus 6 percent, then you should have thrown the kitchen sink at it a long time ago, if not the whole house,” said Richard Barwell, senior economist at BNP Paribas Investment Partners in London. “There’s no certainty about these things. If you genuinely don’t know, you can try to do too much and then correct later. If you do too little and the problem is this big, then you’re in a terrible world.”
That the ECB can freely admit the divergence of opinion within its own ranks over such a first-order economic problem highlights the predicament for central bankers: unsure what’s happening but having to make policy anyway.
Economists surveyed by Bloomberg predict the Governing Council will keep interest rates and the pace of QE unchanged on Thursday, but act later in the year. When Draghi holds his press conference after the decision, he’ll probably reiterate his call for government support via a global alignment of monetary, fiscal and regulatory strategies.
Jarocinski and Lenza modestly conclude the possibility that “policies aimed at stimulating aggregate demand, including fiscal and monetary policies, should play an even more important role in the economic policy mix.”
Inferring how much slack there is left is one way to know when to pump up monetary support and when to let it out again. Another is to guesstimate how far the economy is from practical full employment, since inflation should rise after that point. Get those judgments wrong and too much, or too little, inflation could occur.
So it doesn’t help that the second uncertainty-bomblet dropped by the ECB concerns the the non-accelerating inflation rate of unemployment — known as NAIRU, the level of joblessness at which inflation remains constant. The accounts of the June policy meeting released this month showed the Governing Council discussed the possibility that rate could be a lot lower than previously thought because of labor-market reforms undertaken in countries such as Spain.
“Structural reforms should have had a downward impact” on NAIRU, the accounts showed. “But it was difficult to quantify the impact.”
If the impact is big, the ECB is further away from being able to meet its inflation goal of just under 2 percent than it thought. Projections published in June show officials saw annual price growth, just 0.1 percent that month, rising to an average of 1.6 percent in 2018. A substantial downward revision to the outlook would inevitably lead to calls for more stimulus.
No central banker worth his salt would say they could define precisely where NAIRU is, although most would assume that in the euro area it’s not far below the latest jobless rate of 10.1 percent. Bloomberg economists Maxime Sbaihi and Jamie Murray have calculated a NAIRU for Germany, France, Italy and Spain of around 9 percent, though again it’s hard to factor in structural changes in those economies.
There’s even less certainty about output gaps that Jarocinski and Lenza, like most economists, say are “unobservable.” Instead, modern policy-making is about using rules to get a feel of what’s needed, and then setting policy using judgment.
Martin Weale, a Bank of England policy maker, admitted as much in a speech in London on Monday when speaking about the Taylor Rule, a guide to setting interest rates that central banks often look at — and then ignore.
“The fact that statisticians cannot measure potential output raises questions about practical implementation,” Weale said. “But the principle of setting the interest rate with reference to inflation and the output gap has provided a useful reference point for economists.”
The trickiness of measuring the euro area’s performance is compounded by the sheer variety of its 19 member economies. While Germany with record-low unemployment is probably close to running at full pelt, Italy and France are battling with structural difficulties that depress the region’s growth average.
For James Nixon, head of macro forecasting at Oxford Economics Ltd. in London, the differences in national performance are determined by real-world problems the ECB’s models can’t capture, like Italy’s banking woes. That means pragmatic policy makers may prefer to avoid theoretical controversies.
“The idea of being able to run the European economy by looking at the aggregate measures is problematic,” Nixon said. “The divergences have, if anything, gotten bigger.”