BRIEF: ECB Has Rate Room To Counter Tight Fiscal Policies
MNI (LONDON) - The ECB should be able to offset the fiscal contraction resulting from the EU's new fiscal rules by cutting interest rates, but may need to turn to asset purchases if the neutral level of rates falls to the lower bound of current estimates (estimated between -0.5% to 1.0% by the ECB), according to a Bruegel paper requested by the ECON Committee of the European Parliament.
"The new framework will create a fiscal drag on euro area demand. With inflation back on target, this will need to be offset by the ECB. Conditional on prevailing estimates of the neutral real interest rate (r*), the ECB has is likely to have sufficient firepower to do so solely through interest rate cuts. But if r* turns out to be overestimated or falls, the application of the framework alone could contribute to a new ‘lowflation’ regime in the euro area, which the ECB will need to fight by returning to asset purchases."
The paper bases its calculations on its own estimates of fiscal contraction under the new EU regime of 0.5% in 2025 and 0.3 to 0.2 per year up to 2031 as well as estimates that a one point cut in ECB rates would lead to 0.9% increase in output.