When the European Central Bank’s Governing Council convenes tomorrow in Frankfurt, there will be plenty of talk about Mario Draghi’s recent speech at Jackson Hole. Not only did this open the door to a large-scale quantitative easing (QE) programme, it may in time be seen as a pivotal moment in the evolution of the euro area's policy framework as it attempts to fend off the forces of deflation.
The speech by ECB president Draghi, on unemployment in the euro area, was controversial in two key respects. First, he warned that extraordinarily high rates of unemployment in some euro-area countries could lead to the eventual break-up of the monetary union. Second, he argued that structural reform needs to be accompanied by policies aimed at lifting aggregate demand if the battle against unemployment—and, by extension, the risk of corrosive deflation—is to be won.
Mix of Monetary and Fiscal Policy
Perhaps even more surprisingly, Draghi suggested that monetary and fiscal policy should work in concert to lift aggregate demand, claiming that “the way back to higher employment... is a policy mix that combines monetary, fiscal and structural measures at the union level and at the national level.”
Seem familiar? To us, this sounds a lot like the far-reaching and bold “three arrows” approach pioneered by Japan’s Prime Minister Shinzo Abe in that country’s attempt to defeat persistent deflation. So, does the speech signal the onset of Japanese-style “Draghinomics” in the euro area?
QE on the way
Only time will tell, and much will clearly depend on the extent to which euro-area governments heed Draghi’s warning. But there’s little doubt about the message Draghi wants to convey about the near-term direction of ECB policy. Not only did he make special reference to the recent sharp decline in inflation expectations in the euro area, he also argued that the risks of “doing too little” in the current environment outweigh the costs of “doing too much.”
This is a big change for the ECB, suggesting that it’s moving closer to the thinking used to justify more aggressive and proactive policy responses in the US, the UK and Japan, each of which have already launched large-scale QE programs. If so, it would herald another dovish shift in the ECB’s reaction function—which has already changed markedly under Draghi’s stewardship.
A few weeks ago, we put the probability of a large-scale QE program in the euro area at 30%–40%. However, lackluster data, rising geopolitical risk and Draghi’s speech all suggest this should now be higher. Indeed, we now think a QE program is more likely than not. And while this week’s meeting of the ECB’s Governing Council is probably too early for such a controversial move, we doubt it will be long before Draghi fires the first arrow if the outlook for price stability continues to deteriorate.
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