Central banks typically do not surprise with their decisions. The element of surprise, as another variable in monetary policy, has only proven its worth in extreme situations. We all recall the courage of the European Central Bank (ECB) President, Mario Draghi, at the beginning of the crisis, when he stated that the institution would do “whatever it takes to save the euro.” The situation demanded a clear message amidst the fragmentation of the European financial market. And the measures that followed—pushing traditional expansionary monetary policy to its limits and applying unconventional ones—were sufficient to overcome the financial crisis. European authorities complemented this with other measures to make monetary union more viable. A combination of supply and demand policies unprecedented in our recent history.
The European monetary authority has once again surprised after its latest meeting, more by the timing than by the substance of the measures. Six months ago, it set a strategy for returning monetary policy to normal, ceasing to expand its balance sheet and anticipating a future interest rate hike. Now, it is postponing the planned rate hike and anticipating a new round of medium-term liquidity injection for September. President Draghi, despite viewing the economic future with optimism, considers it appropriate to take these expansionary measures preventively in light of the recent observed economic deterioration. An unwritten rule suggests that the success of preventive monetary policy corresponds to scenarios of strong growth and inflation.
Some analysts interpret the subsequent negative reaction of financial markets as stemming from unresolved questions after the meeting, such as the underlying reason for injecting more liquidity after acknowledging that financial conditions are already expansionary. Persistent doubts about the future consequences of maintaining an overly expansionary monetary policy for too long are amplified by the uncharted territory of, for example, prolonging negative official interest rates. The head of the ECB admitted at the press conference that this issue was a subject of discussion within the Governing Council.
The only tangible outcome was the downward revision of growth forecasts. In addition to expectations of a worse-than-anticipated economic climate, there are uncertainties arising from trade protectionism, Brexit, and how all of this could exacerbate the structural weaknesses of some emerging economies. Injecting more liquidity does not seem to be the appropriate treatment for this accumulation of ills. However, as a placebo, it may be effective in attempting to combat a persistent deterioration of financing conditions in financial markets. The objective of financial stability is once again identified with a sustained financial market, even if artificially so.
Financial markets thrive on confidence. An excess of liquidity can act as a palliative against distrust, but it is important that other types of policies, distinct from monetary policy, take over so that economic agents can once again view the future with optimism. Ultra-expansionary monetary policy provides a crucial window for countries with room for maneuver to develop their own fiscal and supply-side policies. It is also important to increase international coordination to address global risks.
The ECB fulfills its role by designing a monetary policy appropriate for a scenario of low inflation and risks to growth. Private banks are also doing what is appropriate by trying to adapt their strategy to a prolonged exceptional scenario of zero or negative interest rates, increasing non-banking competition, and strict regulation that limits their risk-taking capacity. However, the risks that banks cannot manage are assumed by another part of the financial system that is not subject to regulation as stringent as banking regulation. European banks maintain a stable flow of financing to the private sector above the economy’s nominal growth. In general, they do not need more liquidity, but rather greater certainty about the end of the most distortionary monetary measures applied during the crisis. They also need greater regulatory certainty and the completion of the banking union.
