CENTRAL BANKING can be agonising. The effect of monetary policy on the economy is not immediate, so decisions must be based on expectations for two years’ time. That means putting faith in forecasts that could well turn out to be wrong.
Some soul-searching might be expected at the monetary-policy meeting of the European Central Bank (ECB) on December 13th. Since 2015 it has stimulated the euro-zone economy by buying bonds worth €2.6trn ($3trn) under its quantitative-easing programme. In June it said it planned to stop asset purchases by the end of the year (though it will continue to reinvest proceeds from maturing bonds), and to keep interest rates at their current rock-bottom levels “through the summer” of 2019. Since then, though, economic growth has slowed and inflation, stripped of oil-price rises, has stayed resolutely low. The question is how persistent these developments will be.
After an impressive showing in 2017, the euro zone’s economy has weakened (see chart on next page). Temporary factors bear some of the blame. Poor weather, strikes and a bad flu season marred the start of the year. Then in the third quarter of 2018 output was 0.2% higher than in the second, the slowest growth since 2014. New emissions tests in September meant carmakers put production on hold while they rushed to certify their stock of vehicles. As a result, in the third quarter the German economy—the bloc’s powerhouse—contracted for the first time in nearly four years.
In 2017 trade provided a welcome boost to the euro zone. This year demand for exports has moderated, dampening growth, most notably in Germany and Italy. Domestic demand has picked up some of the slack, particularly in France and Spain. But it has not fully offset the effects of the trade slowdown on the bloc.
Italy’s domestic politics are also concerning. The government’s row with the European Commission over its budget and ensuing market jitters are starting to weigh on sentiment and push up borrowing costs. The country’s GDP shrank in the third quarter as consumption and investment fell. The purchasing managers’ index, a closely watched survey, suggests that output also fell in October and November. An official recession—two consecutive quarters of contraction—could be on the cards.
Italy aside, economists are not predicting a sharp deceleration. Daniele Antonucci of Morgan Stanley, a bank, expects euro-zone growth to slow from 1.9% this year to 1.5% by 2020, broadly in line with his estimate of its long-term growth potential. That might give the ECB some comfort: it means inflation is unlikely to fall.
Even so, weak pricing pressure is testing the ECB’s resolve. In recent months headline inflation has been a little higher than the ECB’s target of “below, but close to” 2%. But that largely reflects past rises in the oil prices; a recent tumble should drag it down. Core inflation (excluding food and energy) has long confounded the bank’s expectations of a rise. Since 2015 it has hovered at around 1%.
ECB officials are convinced that this time is different. Mario Draghi, its boss, is cheered by signs of a pickup in wage growth to 2.3% as unemployment has fallen. This is showing up in salaries rather than bonuses, signalling greater confidence in the economy.
But even in Germany, where wage growth is particularly strong, inflation is low: in October core inflation there was around 1.5%. That may partly reflect Germany’s need for its many exports to stay affordable on global markets. Andrew Benito of Goldman Sachs, an investment bank, thinks that low German inflation limits price pressures across the currency area, because southern countries are trying to regain competitiveness against Germany. That means euro-zone inflation could stay subdued for the next couple of years.
Puzzlingly low core inflation is not solely a European problem. America has seen it too. Indeed, the Federal Reserve’s experience of tightening policy should caution the ECB against ending stimulus too soon. When America’s rate-setters halted their quantitative-easing programme in 2014, they put the long-term unemployment rate—towards which joblessness can fall without pushing up inflation—at 5.2-5.5%. But since then unemployment has fallen much further without sharp price rises. The Fed learnt that the economy had more room to expand safely than it expected; in hindsight, it could probably have kept interest rates lower for longer.
Recent statements by Mr Draghi and his colleagues, however, suggest that the ECB will stick to its plan for now. It sees the growth slowdown as modest, and a pickup in core inflation as imminent.
Mr Benito reckons, however, that disappointing data releases in coming months could eventually prompt a rethink. If it does decide to loosen policy, the ECB will not find it easy to extend QE. The central bank’s holdings of German bonds is nearing its self-imposed limit of a third of a member’s debt stock. Instead, policymakers would probably guide markets to expect a further delay before interest rates rise. This comes with its own problem, however: Mr Draghi is leaving in October 2019, and his successor may have different ideas.
ECB-watchers think another option may be an extension to its targeted long-term repo operations, which offer banks cheap funding in return for lending to households and firms. That would benefit Italian banks most. They are heavy users of the scheme and the stand-off with Brussels has pushed up their borrowing costs.
But to help them would be to ease the market pressure on Italy that might otherwise encourage fiscal rectitude. The agony of setting monetary policy only gets worse when politics comes into play.