Now that the threat of a near-term breakup of the euro area has disappeared, thanks largely to the ECB’s OMT programme, thoughts have turned to the outlook for the ECB’s monetary policy. And, pleased by the recent normalisation in financial market conditions, Draghi signalled at the January Governing Council meeting that the door was now effectively closed to a further rate cut in the near term. This is a message that he is likely to reiterate at his press conference tomorrow.
But is the current level of rates, which is the highest among the major developed economies, really appropriate, particularly in the periphery, where despite the massive decline in market interest rates in recent months, financing conditions for households and non-financial companies remain at elevated levels?
In an attempt to answer this question, we have estimated separate Taylor rules, which provide a simple guide to the appropriate short-term interest rate based on how far inflation and output are from their target or potential levels, for the euro area’s core and periphery. While such a rule is inevitably simplistic, it can prove a powerful rule-of-thumb as to whether current interest rates are appropriate. Indeed, one version of this rule, based upon euro area inflation and unemployment, has in the past tracked ECB policy behaviour relatively closely (see chart 1).
Chart 1: The ECB's key policy rate and the Taylor ruleSource: Datastream and Daiwa Captial Markets Europe Ltd.
Our results suggest, perhaps surprisingly, that for the periphery the ECB’s current policy stance seems to broadly match the recommendations from this rule despite record-high unemployment rates in most of these economies (see chart 2). But for the core, rates are currently well below where they should be.
Chart 2: Taylor rules for the euro area's core and periphery*Core countries include Germany, France, the Netherlands, Belgium, Austria and Finland. The periphery includes Italy, Spain, Portugal and Ireland. Source: Datastream and Daiwa.
But the picture changes dramatically if we extend the Taylor rule into the future. With headline inflation expected to slow markedly in the periphery as past tax hikes start to wash out and price pressures fade quickly amid continued sharp declines in domestic demand, our estimates suggest that the ECB’s current interest rates will become increasingly restrictive for the periphery.
Indeed, by 2014 this rule suggests that the periphery requires a policy rate of -3%, implying that QE is required. And when one takes into account the fact that peripheral short-term interest rates will continue to be significantly higher than those in the core, true financing conditions are likely to be 400 to 500bps tighter this year and next than what these rules suggest are appropriate.
The ECB cannot be too preoccupied by the periphery – it has to set rates for the area as a whole. Indeed, even a refi rate of 75bps will remain too loose for the core. But for the area as a whole, the current policy stance will likely to be too tight. The Taylor rule suggests that over the next couple of months, the ECB should be thinking about further cuts in its main refinancing rate and, possibly, QE.
Of course, these figures do need to be taken with a pinch of salt, in particular given the large degree of uncertainty surrounding exactly where the “equilibrium” unemployment rate is. Nevertheless, the estimates do highlight the challenging environment in which the ECB will have to set policy. Indeed, our forecasts suggest that never has the discrepancy between the rates required by the core and the periphery to stabilise the respective economies have been larger than it will be in the next two years.
This suggests that holding its key policy rates unchanged until at least the end of 2014 might just about give it the best chance of avoiding overheating in the core, while mitigating to some degree the recessionary impact of the ongoing deleveraging process in the periphery. Moreover, through the activation of the ECB’s dormant OMT programme and appropriate fiscal and structural reforms, peripheral governments have the ability to self-induce a further easing of their financing conditions potentially more powerful than any further ECB rate cuts.
Tobias S. Blattner
Euro area Economist