Which way for the ECB?

Ahead of the meeting of the European Central Bank, the debate on the right course for euro-area macroeconomic policies has re-emerged. An interesting new feature of the debate is about differentiating monetary policy to better cater for different conditions in different countries of the euro area. So should there be more differentiation of monetary policy across countries and how much can monetary policy achieve?

Monetary policy first and foremost needs to look at the euro-area aggregate. Inflation as well as core inflation in the euro area is currently at 1.7 percent and the 2-year-ahead market based inflation forecasts are below 1.5 percent. The output gap of the euro area for 2013 as of the February forecast of the European Commission stands at almost 3 percent, suggesting significant slack in the euro-area economy. The area-wide economic indicators therefore clearly signal that the eurozone is in a recession and that inflation is well below the envisaged 2 percent. For the area as a whole, more expansionary macroeconomic policies thus seem warranted.

Turning next to the individual countries of the euro area, the weak economy in the South of Europe is particularly worrisome. Yet, even the strongest countries of the euro area, including Germany, currently record a negative output gap. Inflation in Germany is below 2 percent at 1.8 percent and therefore almost at euro-area average. So in absolute levels, Germany also appears to be entering a recession and the low inflation rate would warrant a further stimulus to the German economy.

The snapshot of the current situation in Germany underestimates the country’s need to be Europe’s growth engine. In the first nine years of monetary union, eurozone economic growth was driven by strong but unsustainable growth in the South. It is now for Germany to grow above average to help correct imbalances. Germany’s inflation rate had been significantly below the euro-area average while in several Southern European countries it had been significantly above average. This relative price divergence may require a correction of prices amounting to 10-20 percent depending on the countries considered. An arithmetic consequence of this past divergence is that going forward, German inflation rates will have to be above the euro-area average. For this to happen, the German economy should be booming.

Would a further rate cut by the ECB help to increase growth and investment in Germany? German banks can currently borrow at a rate that is significantly below the ECB repo rate. A cut in the main rate is therefore unlikely to ease funding conditions for German banks. German ECB board member Joerg Asmussen has therefore warned not to overestimate the effects of a rate cut. Instead, an increase in public investment would be warranted as a way to trigger growth. With German government bond rates at close to zero, any public investment project with a return higher than zero would be beneficial to the German economy.

An ECB rate cut would help banks in the South by lowering their funding conditions. Yet a cut is unlikely to make a significant contribution to overcoming the deep recession in the South of Europe. Banks’ weak balance sheets and the risk of zombification prevent proper transmission of monetary policy signals to the real economy. Funding conditions for corporations remain highly restrictive even when they have profitable business projects. In addition to a rate cut, the ECB should therefore step up its nonstandard measures to promote credit growth, in particular in the South of Europe. This could include loosening collateral standards for corporate credits.

Overall, a rate cut is an important signal to guide market expectations but it is unlikely to make a big contribution to overcoming the recession. Instead, more aggressive measures to repair monetary policy transmission in the South of Europe and public investment in the core of the eurozone are warranted.

* Guntram B. Wolff is deputy director of the Bruegel think tank.