Europe steps into the unknown

The European Central Banks mulls over printing money to ward off the threat of deflation.

"Mario Draghi has gained a reputation for winning the trust of financial markets with words as much as deeds," says the Financial Times. Take the European Central Bank (ECB) president's 2012 promise to do "whatever it takes" to save the eurozone.

This intervention is widely credited with preventing a break-up of the currency union "without having to spend a cent". Yet, Draghi now faces a new threat "one that words alone might not be enough to resolve".

Europe's policymakers are increasingly worried that the region is on the brink of deflation, after the eurozone consumer price index rose by just 0.7% year-on-year in April, far below the ECB's official target of 2%. This is partly due to the strength of the euro up by 6% against the dollar over the past year which has reduced prices of imports.

Several governments have been lobbying the ECB to try to curb the rise in the euro and to take more steps to boost the eurozone's fragile recovery, which could be derailed by a bout of deflation (which makes debts even harder to clear).

At a press conference last week, Draghi indicated that he has come round to this view, stating that the "governing council is comfortable with acting next time". That was seen as a strong hint that the ECB would do something' at its next meeting in June. The question is: what?

One possibility is quantitative easing (QE). This involves the central bank buying assets typically government bonds to increase the money supply and lower long-term interest rates.

QE has been enthusiastically employed by the US Federal Reserve, the Bank of England and the Bank of Japan. But the ECB has steered clear so far, largely because QE remains highly controversial in Europe, with some politicians arguing that the ECB is not allowed to buy up government bonds in this particular manner.

There have been signs that key critics of QE are softening Jens Weidmann, Germany's representative on the ECB governing council said in March that QE is no longer "out of the question".

But launching the policy in June would still be a very significant step and Draghi's language "did not seem quite strong enough to imply that such a bold move was imminent", say Capital Economics. Instead, the ECB is likely to begin with less contentious measures.

What might these be? The main contender is something far more radical than QE in many ways: negative interest rates. Under a negative interest rate policy, the central bank charges banks for the money they leave on deposit with it effectively a tax on savings.

In theory, this will do two things. First, banks may seek to pass that cost onto depositors, which would encourage investors with large euro deposits to switch into other currencies. This should weaken the euro.Second, it should encourage banks to lend more money rather than leave it on deposit, potentially increasing the supply of credit in the weaker eurozone economies, and boosting growth.

But this is all theoretical, as no major central bank has implemented negative rates before. Some smaller ones have experimented with the policy, but results were inconclusive. And there could be unintended consequences: "Banks could try to compensate for the new expense by raising their lending rates, which would be counter-productive," notes The Economist's Free Exchange blog.

However, as Deutsche Bank notes: "Not doing anything next month would in our view completely shatter the ECB's credibility and trigger a further appreciation in the euro exchange rate." So June is likely to see Draghi and his colleagues take another step into the unknown, as central bankers have been doing regularly over the last six years.

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