The ECB’s Difficult Crisis Exit

Jens Weidmann, president of Deutsche Bundesbank, during a TV interview on Mar. 13, 2012

Photograph by Hannelore Foerster/Bloomberg

Jens Weidmann, president of Deutsche Bundesbank, during a TV interview on Mar. 13, 2012

The European Central Bank’s unlimited cheap bank loans have eased market tensions, particularly–in the words of ECB President Mario Draghi–by removing the “tail risk” of a banking crisis provoked by the euro debt situation. But the gusher of loans has caused a rift with Germany’s powerful Bundesbank, whose President Jens Weidmann says the ECB is near the limits of its mandate.

One of the consequences of the ECB’s crisis measures is that the Bundesbank has become an increasingly significant “creditor” to the “debtor” central banks of Italy, Greece, Spain, and other poorer European countries. Before the crisis began, these “peripheral” nations accounted for one-sixth of ECB borrowing; now, they account for two-thirds.

The resultant expansion of the ECB balance sheet to a record €3 trillion has generated unwelcome risks for the Bundesbank, in particular, which must cope with increased liquidity as capital flows into its coffers. The Bundesbank more than doubled its risk provisions last year to cope with the impact of the ECB’s crisis measures.

Concern over those risks led Weidmann to reveal that the ECB is already discussing crisis exit strategies–even as Greece has only just gotten its second bailout, Portugal’s unsustainable borrowing costs are prompting Greek-like concerns, and Spain is in the spotlight over its missed budget deficit target.

Exiting the crisis measures is harder than it looks, though. Normally, central banks unwind from monetary stimulus through a sequence of steps including raising interest rates and withdrawing excess liquidity from the economy (e.g. by selling government bonds or other assets to reverse the cash injection provided when the assets were purchased).

For the ECB, however, exiting will be more complicated because the bank is so integral to battling the debt crisis. For the next year or more, it must balance the need to fight inflation with its effort to aid strapped European banks via cheap loans.

In my interview with Weidmann, he noted that the ECB is “ready to react” to signs of so-called “second-order” inflation effects. These occur when rising energy costs or tax increases to fill fiscal gaps affect the broader economy, leading to wage pressure and higher prices. The bank already forecasts euro zone inflation to remain above its target 2 percent threshold all year–and sees further “upside risk”–even as the region is on the cusp of another recession.

All in all, it’s an uncomfortable situation. Fighting inflation might require lifting rates, but any increase would raise the cost to banks of the ECB’s 3-year loans, since their interest is tied to the benchmark rate (currently set at a record low 1 percent). The ECB may find that it can’t raise rates or withdraw liquidity from the market as long as European banks are depending on it for cheap funding.

I asked Weidmann whether an exit is even possible so long as the euro crisis continues. His answer underscored the ECB’s bedrock commitment to fighting inflation:

We have a clear mandate and a clear hierarchy of our goals, and the first is to maintain price stability…We’re determined to do so. You can be assured we will react if inflation pressures arise.

This is called being stuck between a rock and a hard place. It’s hard to envision the ECB reversing its cash injections until euro zone banks are adequately recapitalized. But as Weidmann pointed out, keeping monetary conditions so loose could reduce the incentive for governments to undertake hard reforms and for banks to sort themselves out.

Fortunately, there’s no indication yet that inflation is poised to surge. Weidmann said price expectations “are still solidly anchored” and there are no signs that rising energy costs and tax increases are driving up other prices. When I asked him about that worrisome second-order inflation effect, he replied: “We don’t see it now.”

The full interview can be viewed here:

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