Christine Lagarde will take up her duties at the European Central Bank (ECB) on the 1st of November. What main challenges will she have to face? Is she in opposition or in line with her predecessor Mario Draghi? What are her strengths and weaknesses? Interview with Eric Chaney, Institut Montaigne’s Economic Advisor.
Christine Lagarde has resigned from the IMF and will take over the presidency of the ECB on November 1st. What are the main challenges she will have to face?
Like the other major central banks, the ECB faces the risk of a pronounced economic slowdown accompanied by excessively low inflation. If these risks, the first of which has started to materialize in Germany - where output is stagnating but wages are rising sharply - were to become reality, the ECB should consider going further than the range of measures announced by Mario Draghi on 12 September.
Let us recall them briefly:
- A decrease in the deposit rate for banks to -0.5% (instead of -0.4%), with a tiering system limiting the impact of this levy for the banks with the highest reserves.
- A resumption of the asset purchase programme for €20 billion per month as from November 1.
- A new targeted long-term bank refinancing operation (TLTRO) on very favourable terms, including the possibility of borrowing at negative rates from the ECB for banks contributing to the funding of the economy.
- A change in forward guidance, which until now has been time-dependent and will now be data-dependent and linked to the objective pursued, i.e. the rise in the inflation rate to 2%.
Mario Draghi acknowledged that the resumption of the purchase program, with no time limit, had not been unanimously accepted. Let us translate: it has been vigorously opposed by several members of the Governing Council, starting with Jens Weidmann, President of the Bundesbank.
Unless an unforeseen economic disaster strikes Europe, these measures should give the ECB time to breathe a little to focus on the welcome gift Mario Draghi handed to Christine Lagarde: the strategic review of the ECB's monetary policy framework. On the menu, and without attempting to be exhaustive: the inflation target, the asset classes eligible for the purchase policy and the associated holding thresholds, the limits of this policy, the risks associated with negative rates, possible alternatives such as direct monetary distribution (helicopter money), the opportunity to issue a centralized digital currency, the publicity of Council debates, not to mention the explosive subject of the weighting of votes in the Council. Let's look at three of these topics: the inflation target, the purchasing program, and direct money distribution as a monetary policy tool.
One debate can hide... two others
Already mentioned by Mario Draghi, the inflation target, a quantitative translation of the ECB's primary mandate, price stability, will be hotly debated. It is now defined as 'close but below 2%', following a compromise between hawks and doves drawn up under the chairmanship of Jean-Claude Trichet. During the first fifteen years of the ECB, average inflation in the euro area remained surprisingly close to 2% (1.9% on average, fitting a 2.0% exponential trend). But, initially caused by the drop in oil prices, a slowdown occurred in 2014, pulling the trend towards zero, before it rose to 1.6% (average 2017-2019). This means that the ECB has been unable to bring inflation back to its target for about six years.
An inflation target at 1%, 2% or 4%?
The new Governor of the Austrian Central Bank, Mr. Holzmann, suggests to take note of the "Japanisation" of the euro area economy, and to set the target at 1.5%. Jacques de Larosière, former Governor of the Banque de France, is even more radical, with a target of 1%. On the other hand, renowned economists, including Olivier Blanchard and Kenneth Rogoff, have put forward raising the target to 4%, so that the central bank would have a comfortable downward margin in the event of a crisis, and is spared the adventure of negative rates in which the Swiss National Bank has been wandering since 2014. Paradoxically, both sides have the same concern: to avoid negative rates, which proponents of a low target consider counterproductive, because they undermine bank profitability. It should be noted in this regard that the aim and subtlety of the measures announced on September 12 is precisely to neutralize the impact of negative rates on banks.
In her answers to the parliamentarians' questions, Christine Lagarde has already taken a position in the debate, in line with the symmetry requirement put forward by Mario Draghi at the Sintra Symposium: explicitly mention that the ECB will seek with the same vigour to raise inflation when it is too low as to lower it when it is too high. Although implicitly, insisting on symmetry is one way of saying that the target should be set at 2% without further ado.
Which is the right target: inflation or the level of prices?
But again, the debate on the inflation target may hide another one, more fundamental. The ECB's mandate is price stability, and there is broad consensus that this is a medium- to long-term objective, as inflation can be subject to large short-term fluctuations, if only because of oil prices. Should we then consider that the real objective should be to maintain an average inflation rate - at 2% for example - over a long period of time? Technically, targeting an average rate of inflation is equivalent to targeting an ideal price level path, whose growth would be steady, at 2% per year. If this was indeed achieved between 1998 and 2014, it has not been the case at all since. However, if monetary policy were to target a 2% long term price path, it would have to achieve an inflation rate above 2% per year in the euro area for several years, in order to catch up on the lost ground. For economies with full employment, such as Germany, the Netherlands or Austria, this would probably mean high inflation rates of 4% or more, and therefore a highly negative real return on savings. One can foresee the political tensions that such a situation would generate. Therefore, to the extent that the debate on the symmetry of monetary policy could be a lessened version of the debate on the nature of the target, it is likely to be heated.
"QE for ever", a contentious drift
In principle, Mario Draghi made it clear that the continuation of the asset purchase policy will henceforth depend on the ECB's success in achieving its objective of a sustainable increase in inflation, rather than on a timetable. But it is not that simple, as the ECB has already bought a lot of government bonds, worth €2,172 billion, of which €519 billion for Germany and €420 billion for France, and in some cases is approaching the limits it has set for itself: not holding more than 33% of a given issue. If the new programme were to last a year or more, the limit would quickly be reached for countries such as Germany or the Netherlands. Raising the holding threshold, to 50% for example, would be legally possible but delicate, and politically explosive, as it could push long-term interest rates in these countries even deeper below zero. Whether decided during the review or when circumstances require, this debate is indeed a political bomb that Mario Draghi left on the desk of the new president.
Direct monetary distribution? No way! Oh, really?
Negative interest rates raise well known pushback from banks and savers’ associations. Although their impact is minimized by the September 12 measures, it is likely that the strategic review will consider possible alternatives. Since Stanley Fischer, Philipp Hildebrand and my former colleague Elga Bartsch proposed in a Blackrock note a form of almost direct financing for the euro area economy - the ECB would have an account from which banks would have to draw to lend directly to all their customers at zero interest rates and without repayment terms - it is difficult to avoid the subject of "helicopter money". Mario Draghi, to whom a journalist pointed out that Stanley Fischer had been his thesis supervisor, merely remarked that any direct financing was ultimately a matter of fiscal policy. Since the Treaties prohibit the ECB from financing States, the answer was: this is a non starter. It should therefore not be a problem for Christine Lagarde. But it could be introduced indirectly through the possibility of issuing a digital currency, either centralized at the ECB or decentralised at the euro area central banks level. If the ECB were to take a step in this direction, which the Swedish, English and Chinese central banks are seriously considering, direct monetary distribution would become technically very simple, since every euro area resident would enjoy the possibility of having a digital money account with the central bank. Again, one debate - the opportunity to issue a digital currency - could hide another, that of direct monetary stimulus.
Through her hearing before the European Parliament's Finance Committee, do you perceive a change in monetary policy in comparison with Mario Draghi?
Christine Lagarde had given detailed answers to MEPs’ written questions and did not try to skirt any oral questions. She drew on her experience as Managing Director of the IMF and carefully avoided taking a position on the debates I have just mentioned. On the other hand, she has supported all Mario Draghi's important initiatives, from the famous "whatever it takes" and the dissuasive weapon against speculation that underpinned it, the OMTs ("outright monetary transactions"), to the call for fiscal policies to take their part in the macro-stimulus effort. Despite all her precautions, she presented herself as determined to assume the legacy of Mario Draghi, often considered in Germany or the Netherlands as an incurable dove. Rather, the differences appeared in the way of communicating and in her preferred non-monetary themes.