The euro zone’s economy has been growing for two years, and new bubbles are already threatening to develop in some real estate and bond markets. It’s time to put an end to the zero interest-rate policy.
The US Federal Reserve has demonstrated how an interest rate reversal can be done cautiously with two-and-a-half years of preparation. It is now time for the European Central Bank (ECB) to at least present a plan to phase out its loose monetary policy. There are four issues it should take into account:
First, a phase-out of the zero interest-rate policy requires a monetary safety net to prevent the sovereign debt crisis from flaring up again. Politicians have not yet solved the causes of the sovereign debt crisis on a widespread scale. For instance, Italy’s government debt is growing unchecked and is already twice as high as the maximum allowed under the Maastricht Treaty.
If the ECB were to abruptly end its zero interest rate policy, and the interest burden increases for debt-ridden countries, it runs the risk of the sovereign debt crisis flaring up again and frustrating the phase-out of the zero interest rate policy. Unfortunately, this risk forces the ECB to keep the OMT safety net it created in mid-2012 in place: It needs to stress that it will buy the bonds of a stumbling country in any worst-case scenario.
“A positive interest rate level counteracts the development of new bubbles in areas such as the German real estate market, reestablishes pressure to reform on countries like Italy and creates incentives to save for retirement.”
Secondly, the ECB should finally interpret its 2-percent inflation target in a manner appropriate to the situation so that it can begin to normalize its monetary policy, even with low inflation. In 2007, a debt bubble burst in the euro zone. After that, economic growth and inflation were unavoidably low for many years. But the ECB nevertheless wants to quickly reach its inflation target of just under 2 percent. With this short-term interpretation of its inflation target, it is fueling expectations in the markets of further rate reductions, because inflation will in fact not increase. However, if the ECB wants to phase out its loose monetary policies, it should finally interpret its inflation target in a manner appropriate to the situation. It should accept the fact that, after a debt bubble has burst, inflation will only slowly increase towards the 2 percent target. Only then can it begin ending its zero interest rate policy.
Thirdly, the ECB should quickly start distancing itself from the zero interest rate. The gross domestic product of the euro area increased by 1.5 percent in 2015. After adjusting for the decline in energy prices, core inflation is at 0.9 percent, so there can be no talk of deflation. The fundamental data in the euro area are no longer so bad that a negative deposit rate on bank reserves is necessary. Calculations on the basis of the so-called Taylor rule suggest that a refinancing rate of 0.5 percent is now appropriate. The ECB should quickly raise its base rate to this level, but not without announcing the increase first. Even then, interest rates will still be at historically low levels and should not stand in the way of business investments that make sense.
Fourthly, the ECB should communicate its intention to achieve a neutral interest rate in the long term. The US Federal Reserve regularly publishes information about where the members of the open market committee see the federal funds target rate going in the long term. The ECB should adopt this practice. With an eye on its inflation target of just under 2 percent and the long-term growth prospects of the euro economy, the neutral refinancing rate in the euro area could be at around 3 percent. By communicating a number like that, the ECB would provide investors with an idea of the level to which the base rate could rise in the long term. The ECB should gradually increase the refinancing rate in the direction of the neutral interest rate, unless that would be clearly contradicted by the economic growth and inflation levels.
An interest rate reversal that is communicated early on, with a safety net against the eruption of a sovereign debt crisis, does not constitute a risk to the economy. On the contrary, a positive interest rate level counteracts the development of new bubbles in areas such as the German real estate market, reestablishes pressure to reform on countries like Italy and creates incentives to save for retirement. The ECB should take advantage of the opportunity for a new start in 2016.
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