Why the ECB Won’t Loosen Its Policy Stance Further

(Bloomberg Opinion) -- The European Central Bank, after sharply revising downward its baseline growth projections and seeing no decisive lifting of the downside risks, could be tempted to signal at its Governing Council meeting on Wednesday that it will pursue a further loosening of its monetary policy stance. That would be consistent with the bank's record under the determined and bold leadership of President Mario Draghi, who hasn't been shy about using unconventional measures to keep the euro zone from slipping into deflation. But the ECB is likely to, and should, refrain from such a move this time due to a growing appreciation of the costs and unintended consequences of the much-delayed handoff to a more comprehensive policy response.

There is increased recognition of the difficult 2019 outlook for the euro zone, which faces both internal and external challenges. This week, the International Monetary Fund followed the ECB by projecting sub-1.5 percent growth. As I have argued, Europe's five largest economies all face domestic political transitions and uncertainties that preclude meaningful pro-growth policy efforts, even as regional cohesion is challenged and external demand softens. This week's announcement by the Trump administration that it's considering imposing tariffs on about $11 billion of imports from Europe adds to the uncertain outlook.

The ECB reportedly has looked into further policy permutations to counter this combination of factors that risks stall speed for regional growth, a longer recession for the most vulnerable European Union countries (such as Italy), renewed debt concerns and financial market instability. Yet, even if such a solution could be found, implementation would likely prove challenging given increasingly stretched transmission channels and mounting economic and financial distortions. And that's before you factor in the upcoming leadership transition at the bank.

Support for negative interest rates – let alone, the ECB setting them at more negative levels – is diminishing as more officials recognize the longer-term incompatibility of such a rate structure with the existing construct of Europe's market economies. Already, many rightly worry about undermining credit extension and harming the provision of long-term financial protection products, which would increase risk aversion and undermine both investment and consumption.

An even more generous use of the ECB's balance sheet is possible, especially as the central bank ended its quantitative easing in December. But, as is increasingly recognized in Europe, that move would come at the cost of aggravating moral hazard risk problems that would amplify the policy impact of growing political populism, while also further delaying banking system restructurings. With time, both could threaten the operational autonomy and political independence of the central bank.

The solution is no great mystery. It has been widely discussed for some time; and its key elements have been covered repeatedly by Draghi in his press conferences and other public remarks, and have also been advocated in the last week by the IMF and the Organization for Economic Cooperation and Development.

What's urgently needed is a handoff to a comprehensive policy response anchored by four pro-growth elements:

Structural reforms aimed at enhancing productivity and growth potential, including a targeted infrastructure initiative.
Fiscal expansion where debt sustainability is not an issue.
Progress in completing the euro zone's key architecture.
And, most difficult, directly addressing pockets of excessive indebtedness and debt overhangs that undermine growth dynamics.

Without the implementation of such a package, even if it's only partial at first, continued ECB monetary activism would have rapidly diminishing benefits, increased costs and wider unintended consequences. Indeed, we may be near or at the point when the sum of this equation is a net negative.

When managing portfolios, new investment professionals are often warned that one of the hardest things is to resist acting when there is nothing to do. They are told not to mistake activism for effectiveness, and to resist trades and portfolio repositioning undertaken just out of habit or just for the sake of it.

The ECB's Governing Council should heed this advice, even if the prospect for a comprehensive policy response by governments is far from overwhelming for now.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net

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

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”