The European Central Bank’s plans to protect a fragile recovery

During Mario Draghi’s recent visit to the Harvard Kennedy School, the impact of the US shutdown, the Fed’s approach to tapering, and Europe’s fragile recovery all featured in discussions with faculty and students. Below are the key points to emerge from the conversation.

Eurozone recovery is fragile, but ECB is prepared to protect it
The Eurozone economic recovery is defined by Draghi as “weak, uneven and fragile”. The Eurozone exited a lengthy recession in the second quarter with annualized GDP growth of 1.2%. However, recent reports on consumer spending and industrial production suggest difficulties in the third quarter. While the European Central Bank did not take any action in its last monthly meeting in early October, the low inflation rate (1.1% in September) leaves room for interest rate cuts and other stimulus measures. Draghi confirms that the ECB has a vast array of tools ready, if needed, to stimulate the Eurozone economy. He also reiterates that the ECB would keep rates at current or lower levels “for an extended period of time”.

Asset quality review on European banks may turn up unexpected shortfall
One important tool is the asset-quality review (AQR) of European banks’ assets, to be held in the next year. Surprisingly, resistance to AQR is not coming from countries such as Spain or Portugal – whose banks would benefit from the imprimatur of ECB supervision – but from countries such as France and Germany, where apparently well-capitalized banks may show negative surprises.

Risk of contagion in the Eurozone is significantly reduced
Recent EU political events are fairly positive. The Italian Prime Minister Enrico Letta won a confidence vote after days of fear that his coalition could collapse. The German Chancellor Angela Merkel, while still looking for a governing partner, won the September elections. As Draghi points out, the Eurozone is in much better health today compared to the recent past. “When you look at periods of instability – in Greece, Portugal, Italy – you see that while instability may be hampering hopes for recovery in these countries it hasn’t really hurt the foundations of the Eurozone as it used to do a few years ago.”

Financial markets are still nervous
Financial markets, however, continue to be nervous. A good example is the market reaction to Ben Bernanke’s statement last June that the Fed might start to taper by year-end and stop quantitative easing when unemployment hit 7%, which is not expected until mid-2014. However, the Fed did not start tapering as anticipated. One of the reasons was the unexpected reaction of financial markets to the prospective change in monetary stance. Regardless of the fact that the Fed has emphasized that “tapering” does not mean “tightening”, investors radically repriced their expectations since June, bond yields rose by nearly 1% and mortgage rates by slightly more. This was clearly an overreaction. Indeed, even with tapering, Fed asset purchases would remain above zero and monetary policy would still be loosening.

When will the Fed start tapering?
There are additional reasons that pressed the Fed to postpone tapering. The pace of job growth has recently slowed and the drop in unemployment has been caused in part by the number of workers no longer looking for a job. The labour market participation rate in August sank to a 35-year low of 63.2%. If data confirms that the economy has overcome higher bond yields, and if the US fiscal contention is resolved quickly, it could be as soon as the end of October.

Unemployment and increasing inequality are the main issues in the US
There is mainstream consensus that unemployment and not inflation is the Fed’s main challenge. Also, income inequality in the US is increasing, with the top 10% grabbing a disproportionately large share of total income. This is partially due to quantitative easing, which has been good for the stock market and thus the wealthy, but has not yet translated into significant additional spending and new jobs.

Risks of uneven recovery
The current three-speed economic recovery could become a challenge due to the strong interconnections among economies. The International Monetary Fund expects emerging countries to grow 5.3% in 2013 (5.7% in 2014), the US 1.9% (3% next year) and the Eurozone 0.3% (1.1% next year). An uneven growth, particularly between the US and the Eurozone, is an element of risk.

In conclusion, both the US and the Eurozone continue to present risks and financial markets are that fragile economic recovery may end. While it may not be the time yet for central banks to stop quantitative easing, the risk of contagion in the Eurozone seems to be significantly reduced and the US economy, notwithstanding the consequences of a government shutdown, seems to have turned. Given the past few years, more than enough reason to be an optimist.

Marco Magnani leads the research project “Italy 2030” as a Senior Fellow at Harvard University. He is a World Economic Forum Young Global Leader.

Image: A tram runs past the euro sign outside the headquarters of the European Central Bank in Frankfurt. REUTERS/Kai Pfaffenbach