Never a hot-bed of monetary policy activism, the European Central Bank may soon find itself forced into an uncomfortable period of experimentation.
At issue is inflation, or rather its increasing scarcity: eurozone inflation fell at its fastest ever month-on-month pace in January, down 1.1 percent from December. Only three small countries, Estonia, Slovakia and Latvia, saw consumer prices rise in the month, with the rest flat or in outright deflation. Annual inflation came in at 0.8 percent, far below the ECB's 2.0 percent target and slightly below economists' expectations.
Indeed with Germany seeing a month-on-month decline in prices, the supposed contrast between a healthy core and sclerotic periphery is harder to see, at least in inflation terms.
"The disinflation trend is broad-based across the eurozone. All countries are contributing to lower inflation. It is not just the internal devaluations of program countries that are pushing euro zone inflation down,» Andrew Bosomworth of Pimco wrote in a note to clients, referring to countries like Greece and Ireland which are following programs of economic reform which have wage, living standard and price compression as unwanted side effects.
Just think what might happen to prices if France and Italy were to some day actually launch the economic reforms they've been threatening these many years.
So far ECB head Mario Draghi, using a narrower definition of deflation, is sounding not exactly like a man ready to pull the trigger on rate reductions or other extraordinary monetary policy.
"We don't have any evidence of people postponing their expenditure plans with a view to buying the same thing at lower prices, in other words we don't see what is defined to be deflation,» Draghi told reporters in Sydney on Sunday after a meeting of the Group of 20 nations.
"We are aware of the risks. The Governing Council is willing and ready to take any action in case these risks were to gain strength."
Early estimates of February inflation will be released on Friday, setting the stage for the next ECB policy meeting on March 6, at which time it will also publish longer-term inflation forecasts for the first time. Financial markets show investors see a 10-basis-point reduction of key ECB rates by mid-year as about a 50-50 proposition.
Even so, if we have learned anything during the past six or so years it is that the dominant central banks on either side of the Atlantic make quite a contrast. Where the Federal Reserve is impatient and quick to move, the ECB, while certainly innovative in tough times, seems more inclined to taking the advantage of time before deciding.
All of which may leave us somewhat surprised if the ECB does react strongly, in no small part because some of the measures it may take will seem radical. One, paying, or charging, a negative interest rate on short-term deposits it holds, would form an incentive for banks to lend or hold riskier instruments, but is unlikely in and of itself to make a huge difference.
Some, particularly the direct buying of bank loans from banks, may also have some key advantages over QE as it has been practiced in the U.S.
While the ECB would prefer to stay away from buying government bonds, which many argue would violate its governing treaty which prohibits monetary financing, the alternatives present their own difficulties.
There simply isn't a big enough and liquid enough asset-backed and covered bond market to give scope for purchases with enough oomph to be meaningful. And while European banks have huge balance sheets full of loans, and good reason to want to offload them and shore up capital, the ECB may not have the expertise needed to negotiate, purchase and manage a huge loan portfolio.
That said, buying loans could work quite well in a European context. Europe is more dependent on bank financing, as opposed to capital markets, than is the U.S., making loan purchases more likely perhaps to stimulate the real economy, as opposed to simply goosing prices in financial markets.
And while the red line of monetary policy in the U.S. is «picking winners» within the economy, which such a program arguably would do, in Europe the taboo is more about financing governments.
Even if the ECB went for credit easing, as buying bank loans can be called, it will have a hard time buying enough. With money supply in the eurozone about 1.4 trillion euros short (by Pimco estimates) of its pre-crisis trend, the ECB will need to buy a whole heck of a lot of something to address the inflation drought.
Innovative as it may become, to achieve that scale of stimulus will be hard without buying government debt, taboo as it may be.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)