The ECB Should Fully Use its Balance Sheet to Fight Deflation

The goal of this note is to support the view that the European Central Bank (ECB) should fully use its balance sheet to bring back inflation in the euro area to a reasonable level.  It comprises four recommendations, which are drawn from an analysis of the monetary policy pursued by the ECB and by the Federal Reserve (FED).

The ECB must loosen its monetary policy stance

There are enough indicators confirming the need to ease monetary policy in the euro area.  The growth and inflation figures leave no doubt about this.  In the United States, the US economy has grown by 2.3% since 2010, whereas the inflation rate remained anchored at 2%.  In the euro area, real growth averaged 0.7% during the same period, while the inflation rate has been going down all the time since the end of 2011 (see Charts 1 and 2).



Overall, the evolution of the consumer price index on both sides of the Atlantic has been comparable, whereas M2 has increased in the United States at an annual rate of 6.5% since 2010, compared to 2.9% in the euro area and 1.8% for M3 (see Charts 3 and 4).

The weakness of monetary growth since 2009 provides a strong signal that the monetary policy stance has been too restrictive for too long.  To paragraph Milton Friedman’s famous statement, it can be argued that GDP growth is always and everywhere a monetary phenomenon in the sense that monetary growth is necessary for an economy to grow at a sustained pace over time.

In this respect, it should be recalled that at its creation the ECB gave special importance to a reference value of 4.5% for the annual growth of M3.  It abandoned this policy when it considered that the relationship between M3 and inflation was unstable and that its high credibility as a “hard-nosed” central bank was sufficiently strong.

The current level of inflation in the euro area is questioning this change of policy strategy.  It is also widely recognized that the annual growth rate of M3 observed before the financial crisis (7.1% in 2000-2005 and 10% in 2006-2007) contributed to the emergence of bubbles during this period in a number of member states.

These considerations suggest that the ECB should be pay more attention to monetary aggregates, and change its policy stance whenever the monetary dynamics appears too strong like in 2006-2007 and too weak as is the case at present.

The ECB should increase its balance sheet as long as necessary

Chart 5 compares how the balance sheet of the ECB and of the FED have increased in recent years.   In the United States, the bankrupcy of Lehman Brothers was a game changer for the FED.  Since then, its balance sheet has risen almost continuously.  On the other hand, the ECB kept its balance sheet more or less stable between 2008 Q4 and 2011 Q3, presumably under the assumption that the interest rate cuts to 1% would bring enough monetary support to the real economy (see Chart 6).

The worsening of the sovereign debt crisis amid rising doubt about the sustainability of the euro changed that situation.  In response, the ECB launched in December 2011 an ambitious program of long-term refinancing operations (LTROs) to provide liquidity for euro bank banks holding illiquid assets.   This initiative led to an expansion of the ECB’s balance sheet from EUR 2.3 trillion at end September 2011 to EUR 3.1 one year later.  However, this rise has been followed by a period of deleveraging.  This caused the balance sheet of the FED and the ECB to diverge markedly since September 2012.  It is hard to believe that this evolution has not played a key role in the diverging economic performance of the United States and the euro area.

The FED experience shows that when the official interest rates reach the zero lower bound, the use of the central bank’s balance sheet can be helpful and consistent with the maintenance of price stability.  It also shows that the increase in the balance sheet may have to be significant and extended for a certain period of time.

These observations suggest that the ECB is right to intend to increase its balance sheet significantly.   However, instead of adopting a specific balance sheet level, the ECB should commit to expand its balance sheet by a given amount according to a pre-announced schedule as long as necessary to bring back inflation to at least 2.5%.  This target seems reasonable given that the inflation rate has been well below 2% since August 2013 and is expected to remain low for an extended period of time.  This commitment would be the ECB version of the announcement made by the FED in December 2012 that it would keep the federal funds rate exceptionally low “well past the time that the employment rate declines below 6.5%”.

This approach would have two advantages.  First, it would provide economic actors with the assurance that the ECB would do whatever it takes to bring back inflation rate to an average level close to 2%.  Second, the ECB would not have to increase its balance sheet to EUR 3 trillion if the ongoing initiatives to strengthen economic growth would allow a faster pick-up in inflation than currently anticipated. This approach would extend the commitment recently made by the ECB to keep its base rates at a low level for an extended period of time.  In a situation in which interest rates should fall below zero to have a decisive impact on economic growth, “forward guidance” should aim at announcing how the central bank will use its balance sheet to boost nominal demand.

The ECB should use quantitative easing to get around the banks’ balance sheet constraints

Another reason explains why the ECB has been less successful than the FED in using its balance sheet.  As noted above, the ECB’s primary objective was to alleviate the impact of the sovereign debt crisis and improve the monetary policy transmission to the real economy through the banking sector.

This initiative had the effect of increasing the ECB’s balance sheet.  However, this was a very different approach from the one adopted by the FED, which decided to resort to quantitative easing (QE) by undertaking a program of purchases of government securities and other securities from the market.  The first phase of this program was implemented started between December 2008 and March 2010.  By March 2010, the FED held USD 1.9 trillion of Treasury securities and mortgage-backed securities, compared to USD 540 billion at end 2008 (see Chart 7).  When it appeared that economy growth was slowing down somewhat during the summer of 2010, the FED launched a second round of QE which continued until June 2011.  And the third round started in September 2012, when the Fed announced made an open-ended commitment to purchase USD 40 billion agency mortgage-backed securities per month until the labor market improves “substantially”.

Whilst one can speculate on the importance of the effects that QE would have in the euro area, the ECB should not be too quick to brush QE aside.  QE can indeed take effect through a number of different channels.  In a nutshell, QE lowers the interest rates on the securities purchased; it increases the price of the assets that bought to replace the securities that are sold the central bank; it allows banks to shift risky assets off their balance sheets and get the capital relief; it depresses the exchange rate; and it signals the central bank’s commitment to achieve its inflation objective and boost economic growth.

It can also be argued that the ECB has no other choice but to accept QE if it wants to make an open-ended commitment to increase its balance sheet.  The experience so far with the targeted long-term refinancing operations indeed indicates that the demand for liquidity in the banking sector remains too low.

The ECB should support the Capital Markets Union initiative

Compared to the United States, the structure of the euro area economy has two major shortcomings: the financing of its small and medium-sized enterprises is too much dependent on the banking sector, and the financing of pension provision is too much dependent on the public sector.

The excessive dependency on bank financing contributes to explain why the recovery of the euro area economy is so slow.  The global financial crisis has had a dramatic impact on the balance sheet of many banks, and led a process of bank deleveraging that has reduced companies’ access to financing.  Whereas the progress made in implementing the Banking Union will strengthen the resilience of euro area banks in the future, advancing with the agenda of the new European Commission to establish a Capital Markets Union (CMU) will diversify the sources of financing of the European economy.

The potential offered by CMU would be even greater if funded pension plans could develop further in Europe.  This would not only strengthen the financial sustainability of pension systems but it would also have a positive impact on the size and depth of the capital markets in Europe and their integration.  In this regard, the steps taken by the European Commission to create a single market for personal pension products would usefully complement the CMU initiative.

The development of a genuine CMU will also reduce the dependency of the ECB upon the banks for the transmission of its monetary policy by providing larger pools of financial assets to carry out its monetary policy and pursue QE whenever necessary.  For this reason, the ECB should use all its weight to influence the preparation and execution of this project.


Paul Volcker will remain famous in the history for the decisive and courageous decisions he took to end the high levels of inflation seen in the United States during the 1970s.  This should be a source of inspiration for Mario Draghi, who should continue on the progress achieved since his famous “whatever it takes” speech and persuade his colleagues to fight deflation by taking measures as bold than those that were taken by Volcker.