Should the ECB Go Big?

ECB chief Mario Draghi has it tough. Consider his role: He is responsible for guiding monetary policy for an 18-nation currency bloc (soon to be 19!). Those 18 (soon to be 19!) countries have different economic pressures, inflation pressures and more. The history of central banking is dotted with failure from around the world-and that's for central bankers with only one country to worry about! Yet thus far into his tenure, Draghi seems to have had a fair bit of success. But you wouldn't know it from the media coverage, which seems convinced "Dithering" Draghi is moving too slow to stanch a looming deflationary spiral-a cycle of falling prices curtailing consumption, resulting in lower prices, and so on. In our view, though, eurozone stocks and the economy benefit from Draghi ignoring calls for more monetary measures.

Too-slow-go Mario accusations rose again Thursday, after the ECB did nothing. That is, they announced target rates and facilities established in June would remain unchanged: The main overnight lending rate remains 0.15% and the deposit rate -0.10%. The new long-term refinancing facilities (LTROs) were untouched. This non-action led to a swift reaction in the punditry, some of whom have for months pointed to falling headline inflation as a sign deflation has taken hold of the eurozone. Draghi, these pundits claim, is fiddling while Rome burns. Never mind that the LTROs haven't even kicked off yet-they were scheduled for September from Day One. How can you rule something ineffective when it hasn't started yet? Even if the LTROs were going, monetary policy usually works at a lag-it can take months for central bank moves to start impacting loan growth and the real economy.

But you won't hear that from the punditry, who claim June's measures were way too small and the ECB should go big! And by "big," most mean buying long-term bonds and injecting banks with cash they could, in turn, lend-quantitative easing (QE). This, they claim, will spur inflation and get the eurozone recovery on terra firma. But there are a fair few issues with this notion, in our view. For one: There is no actual evidence QE is inflationary. There is much more evidence it slows loan growth, and hence, dampens inflation. US loan growth was the slowest of the last five expansions before the Fed "tapered" QE. After tapering started in January, total lending rose sharply and inflation ticked up some, likely as a result. A very similar thing happened in the UK, where lending and broad money supply contracted for much of QE. Japan, in its 2001-2006 round of QE, did not see materially higher inflation.

Why might that be? While many folks focus on interest rates as the be-all, end-all indicator of loose or tight monetary policy, this can mislead. The elephant in the room is the money supply. Boost it, and monetary policy is theoretically looser. Often that means lower interest rates, but not always. QE lowers long-term rates, but it actually weighs on money supply growth. By depressing long-term rates while short rates were held near zero, QE narrowed the gap between them-the yield spread, directly related to banks' loan profitability. Banks borrow short-term and lend long-term-part of a process (somewhat existentially) called maturity transformation-and a core source of traditional bank revenue and profit. Bankers are people and people respond to incentives. If you reduce the profitability of lending, you reduce the incentive to lend. Less lending constricts the money supply. In this way, both theory and actual experience suggest QE would make money tighter and risk deflation.

We say "risk deflation" because the eurozone is not in deflation today. It is in disinflation (a slowing rate of rising prices). Even this view is somewhat skewed. Most of the downward price pressures are falling energy and food prices-factors most central banks do not much heed in crafting policy. Falling prices in these volatile categories are likely tied to factors outside the reach of monetary policy. We sincerely doubt most pundits would like to argue higher energy and food prices would be super stimulative for the eurozone economy.^[i] The ECB also has no influence over weather or, for example, Libya's ability to export oil and gas. Even if the ECB were to boost money supply more, energy prices (down -1.0% in July's read) could fall further if, for example, warm weather holds in Europe.

Now, even outside food and energy, eurozone core inflation is not exactly galloping. That much we won't argue with. But the core inflation trend is actually flattish lately. In our view, this says less about monetary policy than it does another role Mr. Draghi is about to assume: head of the eurozone's primary bank regulator. The ECB recently gained the role and is planning to conduct stress tests this fall. It has said publicly the tests will be strict, and there is a lack of clarity around what failure might mean. Some analysts suggest it may mean those banks get "resolved."^[ii] If you face a test with liquidation as a potential outcome, our guess is you'd over-prepare for that test. That means raising and hoarding capital, in this case-not lending.

Now, this isn't to say we won't see deflationary readings in the eurozone looking ahead. We very well may. But the economic impact of deflation as a leading economic indicator is spotty anyway. Mild, occasional deflationary readings aren't themselves a canary in a coal mine. The bigger risk would be Draghi heeding calls for QE to quell eurozone deflation: a case of misdiagnosing the problem, then applying the incorrect prescription with potentially negative results. If Draghi seeks to boost lending, buying bonds isn't necessary. Just getting some regulatory clarity should do the trick just fine.