Last week’s announcement by Mario Draghi that the European Central Bank (ECB) has every intention to continue with its 60 billion euros-a-month asset purchase program through September 2016 is to be welcomed, since Europe’s economic recovery is far from secure and its deflation threat is far from over. This makes it far too early for the ECB to start thinking about reversing course.
{mosads}During the first quarter of 2015, the European economic recovery did pick up to an annualized rate of around 1.5 percent, which was better than that recorded in the United States. Yet despite that pick-up, Europe’s real gross domestic product (GDP) in the first quarter was still around 2 percent below its peak level in 2008 before the onset of the Great Recession. This stands in stark contrast to the United States, where real GDP is now some 8 percent above its 2008 peak.
Of equal concern to the ECB should be the fact that the European economy was supported by a number of factors that could prove to be transitory. Not only did the European economy get a big boost from an approximate halving of the international oil price; it also was supported by a marked depreciation of the euro and by a decline in long-term interest rates to record low levels. Also supporting the European economy was a relatively favorable international economic growth climate.
In recent months, each of the factors that have been supporting the European economic recovery have been partially reversed. International oil prices have now increased by around 30 percent from their trough, the euro has bounced by around 6 percent from its lows, and there has also been a marked sell-off in the European bond markets that has raised long-term European interest rates. In addition, it would seem that the economic slowdown in China and in the other major emerging market economies, which had hitherto been the main source of global economic growth, continues apace and shows little sign of ending anytime soon.
From a policy perspective, one would think that the ECB also has to be mindful of the downside risks to European economic growth from possible economic and political developments in Greece and Ukraine. Sadly, Greece’s seeming stalemate in its negotiations with its European creditors raises the distinct possibility of a Greek default and possible exit from the euro well before year-end. Meanwhile, Russia’s continued meddling in Ukraine poses a distinct geopolitical risk to Europe, which hardly would be conducive to a revival in European investor confidence.
Any slowing in the European economy now would pose considerable challenges to the ECB in the attainment of its basic objective of an inflation rate of close to, but below, 2 percent. As ECB President Draghi recognizes, with European unemployment stuck at around 11.25 percent, Europe’s labor and output market gaps remain large. As long as such large gaps persist, one has to expect continued downward pressure on wages and prices. With headline inflation already at around zero and with core price inflation at 0.6 percent, a further deceleration in inflation risks pushing Europe into outright price deflation.
To be sure, there are long-term risks associated with a continued highly accommodative monetary policy stance. In particular, there is the real danger that markets are encouraged to take on excessive risk that could have longer term consequences for economic performance. However, considering that there is the real risk that Europe could succumb to Japanese-style deflation in the absence of adequate monetary policy support, one has to be encouraged that the ECB appears to be sticking to its guns of vigorously pursuing an unorthodox monetary policy.
Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.