The ECB Can Still Do More to Help Europe

(Bloomberg Opinion) -- The European Central Bank announces on Thursday whether it will take more steps to counter the pandemic's economic shock. As euro-zone countries continue to reopen, there is still much uncertainty around the risk of a second wave of Covid-19 and what shape the recovery will take. So the ECB would be wise to err on the side of caution and continue supporting the bloc by expanding its asset-purchase scheme.

The monetary union is still reeling from the sharp decline in activity that occurred in the spring. The euro zone's composite Purchase Manufacturing Index, encompassing all sectors, hit 31.9 in May, up from April but well below the 50 mark that separates contraction from expansion. The unemployment rate in Germany climbed to 6.3% in May — its highest level in four years. In Italy, employment fell by 274,000 between March and April, as the inactivity rate (the proportion of the population out of the labor force) rose from 36.1% to 38.1%.

This contraction has had a notable impact on the inflation rate, which is slipping dangerously close to zero. The price level in the euro zone rose by a mere 0.1% in May compared with the previous year, with Spain and Italy registering declines. The reduction in the inflation rate is largely due to the sharp fall in energy prices, seeing as core inflation, which strips away more volatile items, appeared stable at 0.9%. But even the latter is significantly lower than the ECB's target of keeping inflation below but close to 2% over the medium term.

In normal times, there would be a cogent case for waiting before issuing more stimulus. The ECB has already launched a flexible 750 billion-euro ($840 billion) asset-purchase program to counter the effects of the pandemic, as well as a very generous scheme of cheap loans to the banking system.

And it's not yet clear what will be needed next: Lockdowns are being progressively eased, without so far leading to a sustained surge in new Covid-19 cases. Scientists are even debating if the SARS-CoV-2 virus has lost strength and if warmer weather helps reduce the risk of contagion. Answering these questions is crucial for understanding how quickly and fully we can reopen; uncertainty makes it much harder for economists to make meaningful forecasts and for policy makers to decide on next steps.

But, of course, these are not normal times. The euro zone is an oil importer, so low energy prices are a net positive for the economy. However, if this causes inflation to stay low for too long, there would be a dampening effect on wage negotiations, as workers only ask for moderate pay rises. Such second-order effects could push the economy close to outright deflation — an outcome the ECB has sought to avoid for some time.

The bank also has to be mindful of financial stability. Thanks to its intervention, government bond yields in countries such as Greece, Italy and Spain have fallen in recent weeks, even though their governments are expected to run very large budget deficits. As ECB president Christine Lagarde learned in March, it takes little to spook markets. Increasing the size of the pandemic-related asset-purchase scheme by, say, 500 billion euros, and extending its duration beyond 2020, would signal to investors that the ECB is here to stay as a calming presence.

There are two possible political objections to this course of action. First, Germany's Constitutional Court ruled last month that the ECB failed to justify the proportionality of its conventional quantitative easing program. Although the court did not form a view on the pandemic-related scheme, the two are obviously related. Second, EU governments are debating a 750 billion-euro “recovery fund” to help the countries that suffered most from the pandemic. Further ECB action risks taking the pressure off these negotiations, halting what would be a historic innovation in fiscal policy.

And yet, the ECB would be wading into dangerous waters if it constrained its actions as a result of Germany's Constitutional Court, since this would amount to a severe and unjustified limitation of the independence of its monetary policy. Moreover, the ECB should be guided by its mandate, rather than engaging in games of chicken with politicians on the recovery fund. While inflation remains well below the central bank's objective, there is really no good reason to wait.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg View. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.