The ECB Is Struggling With Three Big Questions

(Bloomberg Opinion) -- For the best part of a decade, politicians and investors have looked at the European Central Bank as a guiding light through uncertain economic times. They may need to adapt to a new reality. On three important questions for the future of the euro zone, the ECB just cannot make its mind up.

The first dilemma is the outlook. The central bank can't decide whether the current “soft patch” is the start of something worse. This matters enormously for the direction of monetary policy. The ECB has already halted its process of “normalization,” choosing instead to extend a new round of cheap loans to the banks and to delay the expected resumption of interest rate hikes. But were the mood to darken significantly, with the euro zone perhaps entering a recession, the thorny question of whether to restart quantitative easing would suddenly reemerge.

In a speech in Frankfurt on Wednesday, ECB president Mario Draghi walked a fine line between gloom and cheer. He acknowledged that the outlook was worse than the central bank had expected at the end of last year, as external demand suffered from global trade tensions. Uncertainty had begun to weigh on investment, he said, especially for companies exposed to foreign markets.

Yet there are still pockets of resilience. Consumers appear much less perturbed, as they benefit from a relatively strong labor market and rising wages. Financial conditions remain favorable, which should ease some of the pressure on investment. Governments are also spending more as fiscal policy has turned mildly expansionary. The mixed picture suggests that the ECB needs to be watchful, but it doesn't yet make a cast-iron case for more large-scale monetary easing.

The second puzzle for policymakers is inflation. This dilemma faces other central banks too, including the U.S. Federal Reserve. While wages keep rising in the currency union, there's little sign that this is pushing up inflation in a sustained way. Draghi said this was in part the consequence of the previous long recession, which has made companies reluctant to be the first to lift prices and risk a loss of market share. They may also be cautious because of the uncertain economic outlook. A stronger euro has pushed down the price of imported goods too, making the problem worse.

Nevertheless, none of this is an entirely convincing explanation for stubbornly low inflation. There may be structural factors at play, including the impact of globalization and technological change – something the Fed has been looking at. So long as the mystery remains unsolved, central banks may have little choice but to keep pumping money into the economy to meet their inflation targets.

The last quandary for the ECB is the impact of its policy of negative deposit rates. This means charging banks for the excess reserves they park with the central bank, in the hope that lenders put them to better use in the economy instead. For years, some central bankers, including the Banque de France's Francois Villeroy de Galhau, have argued that this policy hurts the profitability of lenders at already difficult times. But most of the ECB's governing council (including its inner core executive board) has remained unpersuaded.

On Wednesday, Draghi hinted that the negative rate idea might need reassessing. “If necessary, we need to reflect on possible measures that can preserve the favorable implications of negative rates for the economy, while mitigating the side effects, if any,” he said. This was pretty non-committal, but suggests a rethink might be on its way. Could the ECB opt for a tiered system, where the negative deposit rate applies only above a certain exemption threshold? In an interview with Bloomberg News, Peter Praet, the bank's chief economist, said the governing council would need a clear monetary policy case before doing so. Once again, it's hard for investors to read which way the ECB is going to jump.

Like other central banks during the crisis, the ECB has adopted a policy of “forward guidance” to give consumers, companies and markets as much information as possible about its next moves. But with the outlook so hazy, and three executive board members, including Draghi, stepping down this year, it can no longer supply all the answers. A new era of unpredictability, and volatility, may be upon us.

To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net

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 Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.