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The ECB’s Leap into the Unknown

FRANKFURT – The European Central Bank is in the middle of a big, risky experiment. Key interest rates have remained close to zero for six years now. Financial markets are flooded with liquidity. Crisis management has resulted in major market distortions, with some segments’ performance no longer explainable by fundamental economic data. The unintended consequences of this policy are increasingly visible – and will become increasingly tangible with the US Federal Reserve’s exit from post-2008 ultra-loose monetary policy.

And yet Europe’s crisis is far from over, as the decisions by the European Central Bank’s Governing Council in June and September demonstrate. This reflects two factors: too little ambition in carrying out essential balance-sheet corrections, and slow progress – negligible in France and Italy – in restructuring Europe’s national economies.

The ECB’s decision to double down on monetary stimulus should thus be regarded as an act of desperation. Its key rate has been cut to 0.05%, the deposit rate is negative, and targeted longer-term refinancing operations are supposed to support bank lending. Moreover, the asset-backed securities market is to be revived by the purchase of ABSs. All of this is intended to flood the markets, expand the euro system’s balance sheet by €700 billion ($890 billion), and return to the balance-sheet volume recorded at the start of 2012.

The expansion of the ECB’s balance sheet and the targeted depreciation of the euro should help to bring the eurozone’s short-term inflation rate close to 2% and thus reduce deflationary risks. For the first time in its history, the ECB appears to be pursuing an exchange-rate target. As was the case for the Bank of Japan, the external value of the currency will become an important instrument in the framework of a new strategic approach.