Having flown largely below the radar of an increasingly polarized discussion on how to respond to the coronavirus, the European Central Bank will be on center stage when its governing council meets Thursday in Frankfurt. The meeting comes at a time when the economic and financial damage is severely aggravating what already were complicated policy challenges due to the Eurozone’s secularly weak growth and inflation dynamics, as well as limited policy flexibility.
It’s not so long ago (just over a month, to be exact) that conventional wisdom felt that Christine Lagarde would have time to heal divisions on the governing council, advance the ECB’s strategic review, and expand available policy tools. She had assumed the presidency from Mario Draghi in November with a preset policy path in place for the next six to nine months. This view has now gone as the region’s problems have accelerated and amplified.
The worrisomely fast spread of the coronavirus in Italy has led the government to impose a nationwide shutdown. The resulting supply and demand destruction will devastate the country’s growth outlook and resurface concerns about its indebtedness and the health of some banks. Italy’s containment strategy, including a heavy emphasis on mandated social distancing, could also have a “demonstration effect” for other Eurozone economies, increasing the risk of a region-wide sudden stop.
First and foremost for the ECB, this translates into even bigger growth and inflation shortfalls, both immediate and potential. Its policy rates have been persistently negative and it has already resumed a large-scale asset purchase program. Both have been viewed as largely ineffective in solving the nominal growth problems, and risk being counter-productive. The difficulties would be greatly compounded should debt and banking system concerns re-emerge in force.
With all this in play, the ECB invariably faces pressure to be seen to be responding to a serious and worsening situation on the ground. It will be tempted to rely on its usual policy tools, or what behavioral scientists would call in this case the “active inertia” approach. If that happens, the most likely outcome Thursday is some notional cut in policy rates (perhaps 10 basis points), extending and/or expanding asset purchases, and reiterating responsive forward policy guidance.
The economic and financial benefits of such a reaction are likely to be limited, if they’re positive at all. A host of risks would come with them, most importantly the inadvertent signal that the central bank’s policy tools are visibly inadequate.
Unfortunately, and not just for the ECB, the alternatives of keeping policy unchanged or even trying to regain some flexibility aren’t good, either. The former would raise political and popular criticism of insensitivity at a time of economic stress. The latter risks triggering severe market instability and possibly accelerating credit rationing for the most highly-levered companies and sovereigns.
Faced with this reality, the central bank should try very hard to change and regain better control over the policy narrative. The best way involves a dual approach.
The first element is to anchor this round of policy formulation on enhanced and targeted, rather than general, offensive (precautionary) and defensive (damage containment) measures. They should be aimed at reducing the standalone and combined risks of financial instability and regression on bank soundness, as well as inadequate supervision of non-banks, where there is systemic risk.
Second, the ECB could be more proactive in providing a “whole of government” analytical framework needed not just to contain the developing crisis but to push forward the type of comprehensive national and regional pro-growth efforts by governments that have proven frustratingly elusive for too long. Whatever its shortcomings, the bank is the best functioning regional economic institution. It is also best placed for timely global policy coordination.