European Central Bank President Mario Draghi said Monday that the Bank must be alert to negative price spirals in the Eurozone and conceded that there was a risk of deflation in the currency area under certain scenarios.
Speaking as part of the keynote address to the ECB’s annual Forum on Central Banking in Sintra, Portugal, Draghi also said that there was no debate among members of the Governing Council with respect to the Bank’s main goal of returning inflation towards 2% in the medium term and said assets purchases could be used if low inflation were to last for a “too-prolonged” period of time.
“At present, our expectation is that low inflation will be prolonged but gradually return to 2%,” Draghi said. “Our responsibility is nonetheless to be alert to the risks to this scenario that might emerge and prepared for action if they do. What we need to be particularly watchful for at the moment is the potential for a negative spiral to take hold between between low inflation, falling inflation expectations and credit, in particular in stressed countries.”
Draghi acknowledged the dynamics of a potential deflationary spiral in the Eurozone as stressed countries undergo relative price adjustments to regain competitiveness that, coupled with a rising euro, hold down overall area inflation for an extended period of time.
“In this situation, there is a risk that disinflationary expectations take hold,” Draghi said. “This may then cause households and firms to defer expenditure in a classic deflationary cycle – especially when monetary policy is at the effective lower bound and so cannot steer the nominal rate down to compensate.”
The result could mean higher anticipated future debt expectations, which could hold back business investment, household consumption.
“Banks may in turn respond to this situation with stricter credit standards which reinforces disinflationary pressure and hence worsens debt burdens,” Draghi warned. “This is fertile ground for a pernicious negative spiral, which then also affects expectations.”
The ECB President underlined the importance of understanding time lag between monetary policy action and impact on the real economy and noted that “pre-emptive” action may be warranted.
Especially in the light of current impairment of the monetary policy transmission mechanism, there is a risk that a “if a temporary shock turns more persistent, any monetary policy response might arrive too late to prevent a more serious downward shift in expectations,” he cautioned.
On the other hand, Draghi noted that the Eurotower should not be “too reactive to those parts of the disinflationary process that are expected to self-correct.”
Draghi echoed the outline of possible policy responses from his April 24 speech in Amsterdam while putting fresh emphasis on possible measures to counter possible credit constraints.
“An unwarranted tightening of monetary and financial conditions” due to market developments such as a stronger euro could prompt a rate cut, he said.
Should price developments or inflation expectations undershoot the ECB’s target for too long, “this would call for a more expansionary stance, which would be the context for a broad-based asset purchase programme.”
On credit developments, Draghi stressed that “the more the recovery progresses, the more important it is that supply constraints ease so that the recovery can gather steam.”
Draghi said that should lack of credit pose a risk to the recovery as banks continue to repair their balance sheets and capital markets are not ready to substitute, the central bank can step in.
“If, in this context, availability of term funding is a limiting factor on loan origination, then monetary policy can play a bridging role,” Draghi said. “Term-funding of loans, be it on-balance sheet – that is, through refinancing operations – or off-balance sheet – that is, through purchases of asset-backed securities – could help reduce any drag on the recovery coming from temporary credit supply constraints.”