Monday, June 14, 2010

In Defense of the ECB

The ECB has received a considerable amount of criticism in recent weeks, as a result of its decision last month to start buying sovereign debt of some of the euro bloc's most vulnerable countries. The essence of the, at times, surprisingly sharp tone of such criticism is that the ECB has compromised its strongly prized sense of independence and is now succumbing to political pressures to pull out all the stops to contain the fiscal turmoil that has spread ominously across much of the eurozone. Furthermore, the critics argue, by doing so, the ECB is undercutting its much cherished anti-inflation credentials

The ECB's purchases of sovereign, euro-denominated, bonds have been fairly aggressive so far, with a total of over EUR40 billion of such purchases having settled in the first three weeks of the program. ECB watchers expect the program to reach EUR 60 to 70 billion in the foreseeable future. Although no official breakdown is available regarding the issuing countries of the bonds purchased, it is widely believed that the bulk of those purchases involve Greek debt.

The criticism of the ECB on this issue has been unfair and, by most reasonable standards, widely off-the-mark.

Despite the ECB's much publicized single mandate of keeping inflation in the eurozone "below, but close to, 2%", it is always the unspoken, but paramount, responsibility of any central bank to preserve the integrity of the financial system in the country/zone of its operation in periods of pronounced stress. That is exactly what major central banks have always done under such circumstances in recent history, with the most dramatic such episode being the 2008-09 global financial crisis.

In response to the crisis, both the Fed and the ECB took a number of unprecedented measures, some of which were going directly against the traditional concept of a central bank as the ultimate inflation fighter. It was precisely in that context that the Fed engaged in a program of purchasing $300 billion of Treasury securities, crossing a line that was nearly unthinkable in the past- namely of debt monetization; and this, before including the massive program of purchasing mortgage-backed and agency securities, totaling $1.4 trillion. During that period, the ECB conspicuously refrained from purchasing any sovereign debt of its member countries and limited itself to purchasing a total of EUR 60 billion of "eligible covered bonds" in the open market.

That the ECB is coming now under fire for moving aggressively to help extinguish the fire ignited by the fiscal turmoil that has threatened the integrity of the euro, is a serious misreading of its true mission. Meeting the inflation target "over the medium term" is certainly critical, but, first, Mr. Trichet needs to keep the eurozone in one piece to be able to conduct monetary policy with the objective of meeting his single mandate on inflation. There would be no role for the ECB to play if the eurozone collapsed. In fact, it would be negligence, bordering on serious monetary policymaking malpractice, for the ECB to refrain from taking significant special measures in the midst of the bloc's intense fiscal crisis.

As far as the potential inflation repercussions of the ECB's recent program of sovereign debt purchases, the risk appears quite limited. The HICP (Harmonized Index of Consumer prices) for the eurozone is running at 1.5% in the 12-month period to April and is expected to tick higher to 1.6% after the release of the May data tomorrow (6/16/10). Although it does represent an appreciable upturn compared to its low point six months ago and it is still comfortably below the 2% target. Besides, it would be unreasonable to believe that the projected modest pace of eurozone GDP growth in 2010-11 of about 1.5% represents a risk of generating any inflationary impulses.

Mr. Trichet's anti-inflation credentials have been impeccable in the last six and a half years at the helm of the ECB. Inflation is running close to its lowest since the inception of the euro and is lower than the rate prevailing in most legacy countries prior to the creation of the common currency. If anything, he has often been criticized in the past for being overly committed to the ECB's official inflation target, often at the expense of growth in the eurozone and with a steady bias toward keeping monetary policy a notch or two tighter than circumstances might have warranted at various points. (After all, the intense criticism he received for being in a tightening mode in early July 2008 -having raised the ECB's overnight rate by 25 basis points to 4.25% in just two months prior to the Lehman affair- is still fresh).

The ECB and Jean-Claude Trichet have built enough capital with their strong anti-inflation credentials over the years that they should not be viewed with suspicion as to whether they are compromising their commitment to price stability with their bond purchase program in response to an exceptional set of circumstances that they have been confronted with. They deserve more credit than that. Doing otherwise simply highlights the sad reality that markets have, indeed, very short memory.

Anthony Karydakis

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