June 18, 2017 7:00 am JST
Paul Mortimer-Lee

Why the ECB and other central banks are being so cautious

Too much of a good thing could result in deflation

European Central Bank President Mario Draghi arrives to the news conference following the Governing Council meeting in Tallinn, Estonia, on June 8. © Reuters

The recent ECB meeting was very dovish despite great growth. Why are the ECB and other central banks, currently so cautious? They say you can have too much of a good thing -- is that true with the current degree of accommodation?

There are a number of reasons for central banks to walk as if they were on eggshells.

While the Fed will likely have raised rates by 100bp by the June meeting, rates are still uncomfortably close to zero. In previous recessions, the Fed cut rates by at least 500bp. The likelihood of going back to zero is still high.

The Bank of Japan and European Central Bank still have negative rates -- not only are they further away from their inflation targets than the Fed, but their chances of being in the soup if they tighten too soon are higher than for the Fed as they have even less ammunition. The risk of getting monetary policy wrong is even more asymmetrically skewed than for the Fed.

Core inflation is proving to be very stubborn in the current cycle, and the Phillips curve [the relationship between excess capacity/unemployment and inflation] looks much flatter than in earlier episodes -- maybe due to globalization, technology, and lower inflation expectations.

In the US, inflation has surprised to the downside recently and with core PCE inflation at 1.5%, the Fed cannot truthfully claim to be close to its 2% target. The ECB is even further away. It has a slightly different target, "close to but below 2%" which is asymmetric, whereas the Fed is explicitly symmetric. Moreover, the Fed has a dual mandate -- price stability and full employment -- whereas the ECB has only one needle on its compass -- inflation. This means inflation misses are more important for the ECB than the Fed.

Headline inflation in the euro area is currently 1.4% according to the May flash estimate but core inflation is only 0.9%, well away from the target. The ECB's June inflation forecasts have been revised down slightly. The ECB now sees headline inflation averaging 1.5% in 2017, 1.3% in 2018 and 1.6% in 2019.

In Europe, core inflation does not have much of an upward tilt and with the exchange rate stronger recently, the ECB's faith in core inflation trending up any time soon is not strong, despite increased belief in good growth numbers. A significant increase in wage inflation is one of the missing ingredients.

The growth outlook has improved sufficiently so that the latest ECB assessment dropped the previous characterization of growth risks being to the downside; they are now viewed as broadly balanced. Consistent with this change, the ECB no longer explicitly states that rates can go lower than they currently are. However, the ECB appears to be in no rush to shift rates until well after quantitative easing ends and that is slated to continue to until at least December this year. We expect an announcement of QE tapering in September or October, effective from next January, and rates to start to shift upwards only next September.

The ECB's longer-run forecast, as for the Fed, is still for inflation to trend higher. But when do central bankers not forecast that they will get close to target on the policy-relevant horizon?

The chief problem with the current central bank policy stance is that the responsiveness of economies to monetary stimulation seems lower than in the past. Moreover, the responsiveness of inflation to spare capacity seems much attenuated. The net effect is a very weak ability of central banks to affect inflation. However, financial markets are not less affected by monetary policy than in the past. Thus, central bankers may be laying the foundation for future asset price busts. Too easy monetary policy may not result in inflation, but deflation. You can have too much of a good thing, that being ultra-stimulative monetary policy.

Paul Mortimer-Lee is chief market economist and head of U.S. economics at BNP Paribas in New York.

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