President of the German Bundesbank Jens Weidmann and other countries’ central bankers made statements during the week suggesting that negative interest rates or even asset purchases (Outright Monetary Transactions, or OMT) may be considered in upcoming monetary policy announcements. These statements represent a material softening of particularly the German political stance against such measures. Any unconventional monetary policy enacted as a result of shifting eurozone economic sentiment would reduce bond yields, helping governments and banks to pay down their bad debts, and relieve upward pressure on the euro, making European exports more competitive and spurring growth.
The timing of this disruption in the consensus view on unconventional monetary action is noteworthy. In February, Germany’s highest constitutional court criticized OMT and asked the European Court of Justice to determine whether such transactions were even within its mandate, essentially “rejecting” its validity as markets understood the ruling. However, last week the court upheld participation in the European Stability Mechanism, paving the way for further German concessions in the last pillar of the European banking union. This week’s similarly surprising change of heart prompted hopes that OMT actually could be used to support the European economy.
There are several possible reasons for the central bankers’ change of heart. The first is that a slow, incremental shift in consensus has been taking place in economic circles across Europe and is finally coming to the fore. Policymakers and business leaders alike have become less hostile towards unconventional monetary policies, and the fear of unintended consequences from QE has waned. This shift has been even more pronounced since October, when euro area inflation shrunk below 1.0% YOY, a level from which it has not returned. Price growth fell further to 0.7% YOY in February, and data released on Monday is expected to reflect the same weak inflation.
Other drivers of Europe’s re-introduction of OMT could be the result of governments bracing for another difficult year of low economic growth. Risks in Europe, and particularly Germany, are to the downside. Business confidence in CEE, but particularly in Germany, has suffered a sharp fall due to the Crimea crisis. Emerging markets’ currency devaluations have reduced demand for German exports, decreasing new orders for industrial goods. Banks are writing down massive amounts of non-performing loans ahead of ECB bank stress tests, causing a credit contraction that reduces business activity. The risk of a lash-out against austerity in southern Europe has raised fears of increasing political risk and thus higher borrowing costs for those countries, particularly Italy, which could threaten default.
ECB purchases of member government’s bonds and other assets would go far to address these issues. Reduced upward pressure on the euro would help to normalize the exchange rate, making European exports more competitive and improving growth. Lower bond yields would help banks write down bad debt more quickly, reducing the risk of bank failures. Each of these events would improve business confidence, and help bring Europe to a more sustainable recovery.
In short, central bankers’ comments bring the ECB one step closer to assisting its member governments and their banks in balanced deleveraging. This, much more than increased government spending or in lower policy interest rates, would promote growth in Europe.