The fallout from the financial crisis has changed monetary policy beyond recognition, with central banks finding themselves doing things that were previously taboo.

The BoJ, of course, has been most recently at the vanguard of policy action, first setting a 2% inflation target (a move which, admittedly, only brought it into line with the other major central banks) and then announcing a planned doubling in the monetary base to meet that commitment. Those purchases will take the BoJ’s balance sheet to almost 60% of GDP by the end of next year. And more can be expected if inflation doesn’t begin to pick up as the BoJ expects.

The Fed, meanwhile, continues to purchase $85bn of additional MBS and Treasury bonds per month, with its balance sheet heading towards 20% of GDP. And, in response to recent disappointing data, Wednesday’s FOMC statement saw it signal that it was prepared to increase its asset purchases if necessary, a significant change in tone from the previous emphasis on a bias towards gradually winding them up. Another couple of months of weak data and an increase in purchases will be very much on the cards.

Major central bank balance sheets

Source: BoJ, ECB, Fed, Datastream and Daiwa Capital Markets Europe Ltd.

But while policy activism has been the order of the day in Japan and the US, the opposite has been the case in Europe. In the UK, having previously actively employed QE, the BoE appears to have found itself in policy paralysis pending the arrival of the new Governor in July. Mark Carney appears keen to be more active, particularly since the government has changed the BoE’s remit to facilitate just that.

But it is the ECB where policy paralysis is at levels that would have made the “old BoJ” proud. In spite of the fact that the euro area economy has shrunk for five consecutive quarters, it had failed (until yesterday) to reduce its main refi rate to a level reached by the other major central banks at least four years ago. Meanwhile, as the chart above demonstrates, its balance sheet is shrinking, and is set to shrink further, as the outstanding LTRO money gets gradually repaid and its holdings of peripheral government bonds purchased under the SMP (which it in any case “sterilises”) mature. As far as non-standard measures are concerned, the ECB has done all it can to minimise asset purchases. Instead, its non-standard measures have concentrated on liquidity provision to banks.

And the ECB continues to resist further asset purchases. Expectations had been high ahead of yesterday’s meeting that the ECB would announce some sort of programme of assistance for SMEs. Instead, Draghi merely announced a consultation on reviving the ABS market for company loans, which he seemed to suggest would see only a minimal role for the ECB. And when asked about asset purchases, Draghi was clear on setting out what the ECB wouldn’t buy, including, he said, government bonds. So, while another rate cut is on the cards, QE in any form is not, seemingly regardless of the economic outlook. Rate cuts and nothing more seemed to be Draghi’s message.

But, by doing the minimum it feels it can get away with, the ECB is playing a dangerous game. If rate cuts, including the possible introduction of a negative deposit rate, fail to help the economy (and, frankly, they aren’t going to do much to boost activity, certainly not in the periphery), the risk has to be that inflation continues to fall. Excluding the impact of taxes, much of the periphery is already in deflation, something that will help the countries’ relative competitiveness but make the deleveraging underway in those economies even more difficult. If the recent renewed slowdown in the core is not reversed by the ECB’s actions, ever-decreasing inflation there could push inflation across the euro area as a whole into negative territory.

The lesson from Japan is that, once in deflation, escaping it can be nigh on impossible. The vigour of the Fed’s response to the financial crisis is in no small part a result of Ben Bernanke’s deep understanding of the Japanese experience, and the realisation that deflation is something to be avoided at all costs. That is even more true in a world in which, as a recent IMF report suggests, the trade-off between spare capacity and changes in inflation rates has become much weaker than in the past. While this implies that deflation is now harder to get into, it also suggests that escaping it is also much harder – once in it, getting out of it will require the sort of unprecedented policies the BoJ is now starting to undertake.

But, in part reflecting differences in mandates, the ECB views the world through a very different prism to Bernanke’s Fed. For it, deflation is less of a threat than the perceived risks to its reputation, balance sheet and independence that bolder action implies. And in any case, it thinks, monetary policy has its limits, including those that are self-imposed. Only through structural reform, including to bank and government balance sheets, it argues, can true economic recovery be delivered. Every press conference these days sees Draghi say how important all of these things, including banking union, are. And he has a point.

But like the “old” BoJ, which made similar arguments year after year, it is ultimately unable to influence the pace of structural reform – it can only react to what politicians do or don’t do. And with euro area politicians doing the bare minimum they can get away with, austerity hitting growth hard and global demand weakening, even the German economy is spluttering. The ECB’s refusal to be more proactive therefore risks ultimately sacrificing its ability to maintain positive inflation on the alter of central bank purity. And it also risks locking in expectations of exceptionally low (or negative) euro area growth and inflation for the long term, with those expectations ultimately becoming self-fulfilling.

If deflation is indeed the outcome of the ECB’s procrastination, there is little confidence that it would trigger a step change in its behaviour. While deflation may belatedly trigger QE, its history and institutional DNA, which has Bundesbank orthodoxy running through its double helix, suggests that, like the BoJ before it, it would do only the minimum it could get away with. It would certainly not take the sort of dramatic action that could be expected from the Fed or BoE if faced with the same circumstances. Of course, for now, deflation remains a tail risk for the euro area. But the euro area’s institutional set up means that tail risk is more significant than elsewhere. And Draghi’s failure yesterday to signal a willingness to consider the more unorthodox has made that tail just that little bit fatter.

Grant Lewis, Head of Research