FRANKFURT (MNI) – The International Monetary Fund on Wednesday
urged the European Central Bank to consider quantitative easing,
pointing to a “sizeable risk” of negative inflation.

Warning that the “euro area crisis has reached a new and critical
stage” with serious downside risks to economic growth, the IMF’s staff
report for the Eurozone argued that the ECB could provide further
defenses against an escalation of the crisis.

“The ECB has room for lowering rates, and deploying additional
unconventional measures would relieve severe stress in some markets,”
the IMF said.

On interest rates, the IMF said that “economic weakness and
downside risks to inflation in the euro area warrant further
reductions.” While leeway may be limited, any further rate cut would
have strong signal effects and help banks by lowering costs for
outstanding long-term ECB loans, it explained.

The report was concluded on July 3, before of the ECB’s latest rate
cut. ECB policy-makers have since indicated that they would consider a
further reduction in interest rates from the current historic low of
0.75% should economic conditions require. But some ECB Council members
would be more hesitant about the other recommendations of the IMF.

“The ECB could achieve further monetary easing through a
transparent QE program encompassing sizable sovereign bond purchases,
possibly pre-announced over a given period of time,” the IMF suggested.
The central bank has been reluctant to relaunch its government bond
purchases, pointing to the Maastricht Treaty’s prohibition of monetary
financing.

However, once the interest rates tool is fully exhausted and
deflationary risks appear, majorities on the ECB Council may shift. The
central bank is permitted to buy bonds on the secondary market for
monetary policy purposes and – as ECB President Mario Draghi frequently
points out – is obliged to ensure price stability in both directions.

The IMF argued that deflationary pressures are a real risk.
“Inflation is set to decline significantly and could even become
negative,” the report warned. “Given the subdued growth outlook, there
is a sizable risk that inflation could even turn negative in the medium
run,” it said, citing IMF estimates of a 25% probability of below-zero
inflation by early 2014.

The IMF raised the option of reactivating the ECB’s dormant
government bond buying program SMP. In the context of sovereign debt
purchases either via the SMP or a broader QE program, the IMF stressed
the importance of clarifying both the ECB’s and the ESM bailout fund’s
seniority status. “A clear commitment to accept equal status with
private sector claims… would enhance the effectiveness of official
sector crisis management,” it said.

The IMF also suggested that the ECB could further enhance its
liquidity provision with additional long-term tenders “coupled with
adjusted collateral requirements, if needed – including a broadened
collateral base and/or a lowering of haircuts – to address localized
shortages.”

Draghi said at his latest press conference that the collateral
framework would have to be “revisited”. Rejecting concerns of the
Bundesbank, which is opposed to ever laxer rules, the IMF said that “the
associated credit risk to the ECB would be manageable in view of its
strong balance sheet and high levels of capital provisioning.”

— Frankfurt bureau: +49 69 720 142, email: jtreeck@marketnews.com —

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