It's complicated. The ECB is currently juggling two objectives: perpetually assuaging bond investors in the face of a shaky financial system, and managing policy for an economy with a single currency and sovereign government issuers.
But is it really so complicated?
The chart above illustrates the peak (deemed 2008 Q1 here) to trough and recovery of GDP across the G4 (Eurozone, UK, US, and Japan). None of the G4 have returned to 2008 Q1 levels of production (pre-2008). Ironically, as the US Fed readies itself for QE2, the American economy has returned the farthest back up the "production path".
The German recession was deeper, but the rebound has been quick. Annual GDP growth in Q2 2010 was well above potential, 3.7% over the year, and the labor market continues to see gains. But German growth has not been sufficient-enough to bring neither its nor the Eurozone's level of GDP back to pre-2008 levels (as of Q2 2010).
To be sure, 2H 2010 GDP remains to be factored into the recovery in Germany and the Eurozone. Perhaps when all is said and done, Germany will recover smartly in 2H 2010 to generate the final 2.7% bump in GDP to return to pre-2008 levels before the 2011 fiscal austerity measures start to crimp export income. Thus, is the ECB holding pattern correct?
That remains to be seen. If the ECB continues to set policy as it has done so in the past, however, it'll take an economic slap in the face before the ECB reacts to real economic growth and eases further.
The chart illustrates the refi rate (ECB policy rate) at a 2-quarter lead to the annual pace of GDP growth. The relationship is strong and positive, with a correlation of 82%.
The relationship suggests that the ECB's reaction function actually follows economic growth trajectories, but at a two-quarter lag (roughly). For example, the ECB was raising rates into the third quarter of 2008 only to see GDP fall 2.1% at an annual clip in the fourth. It dropped the refi rate by 1.75% in Q4 2010.
The ECB targets inflation, not GDP growth, but the reaction function is roughly 2-quarters lagged to the disinflationary pressures that stem from recession (from my simple exercise, of course). In conclusion, if the ECB is going to react to GDP-induced disinflation signals (i.e., negative growth), then it could get a lot worse in the Eurozone before policy eases further: 1H 2011 is my bet.