Investors were not listening hard enough to Mario Draghi’s recent speech at Jackson Hole. If they were, they would have heard the sound of gears shifting.
At the annual gathering of central bankers last month, the president of the European Central Bank called for more “growth-friendly” fiscal policy across the eurozone and admitted markets had lost faith in his ability to revive inflation. It is conceivable that his speech marked the birth of Japanese-stye Abenomics in Europe. It has certainly pushed the ECB several steps down the road to US-style quantitative easing – large-scale purchases of government bonds.
QE is not the answer to Europe’s problems. It is probably not even a lasting solution to the problem of low inflation. In this, the “hawks” at the ECB who have resisted this step are right, and their more simplistic critics are wrong.
But, as Mr Draghi knows better than most, when it comes to the eurozone we left the world of ideal solutions a long time ago. The question is whether the ECB has reached the point where large-scale QE will do more good than harm, not just for the short-term strength of the economy but for its longer-term health as well.
I believe we have reached that stage, and that Mr Draghi’s remarks at the gathering in Wyoming reflect the same realisation. All that matters now is politics and timing. If the ECB does act, Mr Draghi does not want it to act alone. You might think I was reading too much into Mr Draghi’s comments. The financial markets, after all, were restrained in their applause. But the reality is that Europe’s politics and its economics look different now from the way they did even a few months ago – in ways that should matter to the ECB.
The best but probably least well understood reason the ECB had for not acting sooner was that a bout of very low inflation – in a reforming economy – is not necessarily the end of the world. The strong euro has played havoc with European company profit margins in the past year but it has also boosted household purchasing power at a critical time.
It is noteworthy that consumer confidence in much of Europe has been stable or rising for most of the past 12 months, despite all the talk of the eurozone’s economic woes. The fall in the price of everyday items such as food and energy might have something to do with this “surprising” outcome.
Of course, corporate profits and the productive side of the economy are hurt by a stronger currency – and low inflation makes it harder for countries on Europe’s periphery to become more competitive without cutting wages in cash terms. The longer it continues, the more dangerous it is. But in an economy that is still struggling there are downsides to higher inflation and a weaker currency as well, as Japanese households can attest.
Reforming politicians such as Italy’s Renzi, Italian prime minister, need growth – or the promise of it – to make difficult reforms
The story of Abenomics is far from over – but the typical Japanese household could be forgiven for thinking that all the Bank of Japan had achieved, in pushing down the currency and importing inflation, was another hit to household living standards. Japanese real wages have been falling for most of this year. With the fall in inflation, eurozone real wages have been going up.
The other argument for resisting QE was that it could not solve the structural problems of the eurozone economy. Central bank purchases of eurozone sovereign debt cannot revive Italian productivity growth after nearly two decades of decline. Nor can they reduce the regulatory burden on many French companies. Japan’s experience makes this point, too: monetary policy cannot raise an economy’s potential on its own. To put the recovery on a firmer footing, governments need to act as well.
It should not have escaped anyone’s notice that the points of light in the otherwise bleak GDP numbers for the eurozone were in the countries that have been forced to carry out the deepest structural reforms. Spain, Greece and Ireland all recorded fair to healthy growth in the second quarter. Output was stagnant in France and contracted, yet again, in Italy.
Mr Draghi’s insistence on the importance of structural reform in his Jackson Hole speech was hardly new. What was new was the explicit recognition that fiscal policy should be more flexible, and more supportive of growth, especially in countries with room for greater stimulus (Germany springs to mind).
The larger point is that reforming politicians such as Matteo Renzi, Italian prime minister, need growth – or the promise of it – to make difficult reforms. They also need to demonstrate that the rest of Europe, including the ECB, is doing its bit. To judge by the long-term inflation expectations embedded in market prices, market participants do not expect the ECB to do its bit on inflation for many years to come. Short-term expectations have fallen even more sharply.
That decline is not just down to the ECB; it reflects doubts about the strength of the recovery. But that is the other feature of the landscape that has changed since the start of the summer. The war in Ukraine is having a bigger effect on European confidence and activity than seemed likely only a few months ago.
Mr Draghi and his colleagues are right: the ECB cannot be the only game in town. They are also correct that there is no point in the ECB doing something, simply because “something must be done”. But Mr Draghi was quite explicit in Jackson Hole: the risks of doing too little in Europe are now greater than doing too much. Governments are doing too little. But so is the ECB.
The writer is
chief market strategist for Europe at JPMorgan Asset Management