The monetary policy response function of the European Central Bank (ECB) can be summarized as follows: “We always act within our mandate to keep inflation close to, but below, 2 percent… and when we don’t feel the need to put economic pressure on euro area politicians, we act quickly and forcefully on euro area economic fundamentals.” The decision on Thursday (November 7) to cut the benchmark policy interest rate to 0.25 percent—and to provide unlimited liquidity to the euro area banking system for another year—illustrates that point.
The move to provide liquidity pushes the (potential) withdrawal of unlimited ECB liquidity well beyond the timetable for the upcoming asset quality review (AQR) stress test exercise due to finish in late 2014. It would also extend the window past the expiration of the central bank’s three-year long-term refinancing operations (LTROs) in December 2014 and February 2015. The moves suggest that—unless the ECB fails in its stress test to restore confidence in the euro banking system and reopen interbank lending markets to all peripheral banks—another future LTRO is unlikely. Why should the ECB provide unlimited liquidity beyond mid-2015, when it will have the regulatory power to ensure that banks are adequately capitalized and hence should have no need for central bank liquidity?
President Mario Draghi of the ECB noted in response to questions that the discussion in the bank’s Governing Council was really about whether to act now or at the next meeting in December and that the incoming inflation data swayed the majority toward early action. Asked about the dispute between the ECB and the European Commission over access to public money for a bank deemed viable by the AQR, Draghi said he was “confident that a solution will be found by the time stress tests will take place.”
The answers indicate that the ECB is increasingly confident that euro area leaders will resolve the remaining political issues in the banking union, such as the single resolution mechanism (SRM) and fiscal backstops, before it takes over as the euro area banking regulator. Indeed, the ECB seems so confident that solutions will be found in December in line with the last EU Council’s commitments that there was no political reason to withhold its announced monetary easing to the next ECB meeting. Such confidence in the ability of EU leaders to reach hard political accords is good news for the euro area.
In the long term, the ECB’s latest easing decision reflects how this uniquely independent central bank is gradually being freed from its political requirement to get an explicit quid pro quo ahead of time from euro area political leaders before easing the area’s monetary and financial conditions. As euro area leaders have moved forward in their incremental institutional repair of the “half-built euro area house,” especially with the creation of the European Stability Mechanism (ESM) and the banking union, the central bank no longer has to take the euro area economy hostage to compel political progress on institutional and structural reforms in troubled euro area countries.
As the euro area evolves, the ECB will consequently become more driven by economic fundamentals in a fashion reflecting its status as a more normal central bank. In the face of declining inflation pressures, the ECB is therefore now freer to act. This new freedom does not turn the ECB into an activist Bank of England, US Federal Reserve, or Bank of Japan, with large asset purchases on its balance sheet. But the timing of ECB actions in the future will no longer be as dictated by political developments as in the past—a reflection of the euro area’s new stability. In time, markets may hopefully understand more readily how the ECB works.