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ANALYSIS-Draghi's parting shot leaves next ECB boss with existential dilemma

Reuters | Brussels | Updated: 13-09-2019 20:13 IST | Created: 13-09-2019 20:06 IST
ANALYSIS-Draghi's parting shot leaves next ECB boss with existential dilemma
Image Credit: Reuters

Christine Lagarde will face a momentous decision in her first year as European Central Bank President: give up on reviving inflation or give in to the temptation of bankrolling governments with neverending bond purchases. The ECB pledged on Thursday to buy bonds "for as long as necessary" for inflation expectations in the eurozone to rise to its aim of just under 2 percent - a commitment that will haunt the central bank's decision-makers long after current boss Mario Draghi steps down on Oct. 31.

With the bloc's economy reeling from a global slowdown and incapable of generating enough growth domestically, the ECB could be in the market for years to come, gobbling up significant swathes of the bonds issued by indebted governments. Squaring Draghi's pledge with rules that ban the central bank from financing countries' deficits, and increasingly vocal discontent from some unhappy ECB policymakers will be Lagarde's first challenge when she takes office on Nov. 1, the very day the bond-buying gets underway.

"A purchase program forever means either the final breach of all European Treaties and the beginning of full state financing... (unless) Draghi and his successor get what they want: an inflation rate of 2 percent or more," Sentix, a Frankfurt-based research firm, wrote in a note. Odds on the latter happening any time soon were long, with the ECB itself expecting inflation of just 1.3%-1.6% between this year and 2021 and market gauges of long-term price growth stuck even lower.

But Lagarde won't have the luxury of waiting. In roughly a year the ECB will have bought a third of Germany's outstanding government debt, according to estimates by U.S. brokerage Jefferies, coming up against a self-imposed limit.

Scrapping that cap - designed to prevent the ECB from becoming a blocking minority in any debt restructuring - or diverting purchases to other countries would likely invite fresh legal challenges and accusations Frankfurt is rewarding profligate governments. But giving up on the ECB's mission to bring inflation back to its target was not an option for an institution that has price stability as its sole aim.

Lifting of the share of a country's debt that the ECB could own - likely to 50%, which would still prevent it from becoming the majority owner - was seen by analysts as a possible solution. This would see Frankfurt go down the route of the Bank of Japan (BoJ), which has hoovered up 45% of its government's debt as part of an increasingly desperate effort to revive a stagnant economy via quantitative easing (QE) and fiscal largesse.

"This is QE forever and a next step in the euro zone's Japanification," Carsten Brzeski, an economist at Dutch bank ING said. "The conclusion that only fiscal policy can still make a difference also echoes Japanese experiences." But new ECB President Lagarde would be likely to face pushback on such a move from a sizeable section of the Governing Council, more than a third of which opposed new bond purchases on Thursday, including the central bank governors of France and Germany.

"The very fact there are so many members opposing this could act as an anchor preventing the ECB from following the BoJ," Angel Talavera, an economist at research group Oxford Economics, said.

POLICY REVIEW

Lagarde has a wild card, however. She has hinted at launching a review of the ECB's tools and policy framework to weigh up their costs and benefits. Economists said this could be used to bolster the case for even more stimulus or, on the contrary, acknowledge that the current inflation target is too ambitious and money taps must be finally closed.

When the ECB was founded in 1998, its main preoccupation was to stop prices from rising too fast. It set its central goal as an inflation rate of "below 2 percent", tweaked to "below, but close to, 2% over the medium term" in 2003 to clarify that deflation - or falling prices - would not be tolerated.

But that level of price growth has proven elusive since the eurozone debt crisis of 2010-12 due to a combination of sluggish lending, weak domestic demand in peripheral countries and excess savings in Germany. While nothing is known yet about the spirit of Lagarde's review, Dirk Schumacher, an economist at French bank Natixis, said he saw it as increasingly difficult for QE supporters to justify more largesse.

"The burden of proof is shifting and if inflation has gone nowhere a year from now it will be hard for the doves to say we need more of the same," Schumacher said.


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