EUROPE´S DRIFTERS WAIT BUT INFLATION NEVER COMES / THE FINANCIAL TIMES COMMENT & ANALYSIS

June 8, 2014 3:01 pm

Europe’s drifters wait but inflation never comes

By Wolfgang Münchau

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Draghi is trying a new approach, and if that does not work, he will try another

©Reuters

Is that it? Is a funding for lending scheme really the big idea of the European Central Bank? I was faintly reminded of the scene in Samuel Beckett’s Waiting for Godot where Estragon and Vladimir, the main characters, try on three worn-out hats endlessly in rotation.

Funding for Lending is a two-year-old hat, invented by the Bank of England. The ECB took it, then cut out the only bit of the British scheme that worked – the mortgage lending. From Denmark, the ECB took another well-worn hat: negative interest rates on deposits held by banks. Denmark has since raised interest rates and passed that hat on to the ECB. After the mad hat swapping, we are now back to waiting. Waiting for inflation rates to rise – the Godot of European monetary policy.

The measures taken by the ECB’s governing council are not objectionable in themselves. It is just not clear how they can solve the eurozone’s most pressing problem – low inflation, and the threat that it might persist. The most symbolic measure announced last Thursday, negative interest rates, are probably the least important. Their significance is technical – to control the overnight rate in the money markets, keeping it just above zero. The ECB is now at the lower bound; official interest rates will not fall any further.

Also announced was a programme to buy asset-backed securities – instruments that transform company loans into tradable assets. The problem is that these securities do not exist, at least not in large numbers. The ECB first has to get the European Commission to change regulations. Then it has to create the market, and start buying the stuff. This is not a viable instrument of monetary policy today – although in four years or so when it is finally ready it will constitute the biggest shift in European corporate finance for generations.

That leaves funding for lending, or TLTRO, which Mario Draghi, ECB president, pronounced as “teltro”. It is, by design, a tool to encourage lending. But in common with the other measures, it will do little to make inflation go up.

Will it at least achieve the more modest goal of helping small companies in southern Europe to obtain access to bank loans? That would lift output, and perhaps prices too. The UK Funding for Lending Scheme failed to raise lending to companies by much. But it did spur mortgage lending, and helped drive up house prices in London and other parts of southern England.

The ECB has specifically excluded mortgages from its scheme. I understand that there was disagreement on this point within the ECB’s governing council last week. Some central bankers – from southern Europe especially – wanted mortgages included. The Germans and others resisted – they fear a housing bubble more than they fear deflation. They ended up agreeing on a scheme targeted at small companies only. I expect the €400bn TLTRO to have some effect but not a significant one. In the eurozone, demand for loans and the supply of credit are falling at the same time. Many companies are paying off their debts. Others are funding investment projects out of reserves or earnings. This is a balance-sheet recession of the variety that Richard Koo, chief economist of the Nomura Research Institute, diagnosed in Japan in the 1990s. No matter how great the incentives, many companies do not want to borrow.

Meanwhile, banks want to reduce their risky lending so as to reduce the amount of equity they have to raise under new banking regulations. Also consider that the banks have been busy paying down the previous ECB loans ahead of schedule. They do not want new money from the ECB. In fact, they do not even want to hang on to the money they already have.

Funding for lending is a long-term treatment, not a quick fix. It will be phased in over two years, beginning in September. The first of the loans will be for four years. Still, it may help reinforce the painfully slow recovery in bank lending.

Not one of the new measures addresses the problem of low inflation directly. The ECB’s latest forecast says that headline inflation will remain below its 2 per cent inflation target until late 2016. The trouble is that, once low inflation sets in and is allowed to persist for a long period, it can be extremely difficult to increase the rate at which prices rise.

My sense is that the ECB has given up trying to boost inflation directly. Quantitative easing will happen eventually – not as a pre-emptive strike but as a last desperate shot. The trigger will be a further fall in inflation, or a realisation that prices will never go up – whichever comes first. There are formidable political and technical obstacles to QE. They have not been resolved. TLTRO was approved unanimously. QE will be more contentious.

As Mr Draghi declared on Thursday: “We are not done here.” Then again, nor were Estragon and Vladimir. The hat-swapping scene went an uncomfortably long time.

Copyright The Financial Times Limited 2014.