Draghi’s “Shock and Awe”?
Reading this post (below) from Erwan Mahé makes one ponder if the people at the head of the ECB have understood that we’re fighting for the future of Europe… and not just of the banks and the well to do.
From: Erwan Mahé (guest post)
“His references to core inflation and wage growth represent another semantic shift toward the dual mandate of the Fed, which also argues for a further monetary easing”.
The consensus of investors on what sort of moves the ECB may take following its next meeting on 3 December seems to dovetail with the opinion expressed in my last Thaler’s Corner
… “a 10-bps cut in the deposit rate, bringing it to -0.30%, and a 6-month extension of the QE to March 2017. And we cannot exclude additional measures like ending the 25% QE limit on triple-A issues and a corporate QE programme.”
In any case, that is how I interpret the recent behaviour of the euro (1.068 USD), of the short part of the European yield curve (-0.39% on the Schatz) and of stockmarkets (3440 Euro Stoxx 50). Now, and this explains today’s title (a take-off from the Thaler’s Corner of 19 March 2009 following the launch of the QE in the US), I believe it is increasingly likely that Mr Draghi will go beyond consensus expectations. Just imagine the reaction of markets, if the deposit facility rate were to be lashed to -0.50% ! Such a move would resemble the tactic developed by Harlan K. Ullman and James P. Wade Jr. in their 1996 essay, Shock and Awe: Achieving Rapid Dominance, based on the idea of achieving military victory by taking your enemy by surprise and with overwhelming force.
However, as I have said many times before, that sort of monetary activism would not provide any real answers in the fight against lowflation on the eurozone! In fact, negative interest rates are nothing less than a disguised tax and, unless the tax resources are distributed in such a way as to prop up aggregate demand, the approach can in now way offset the current output gap (although there is still hope on that front too). So let’s see what could possibly warrant such activism in the latest statements by ECB board members.
Let’s give credit where credit is due by starting with Mr Draghi’s speech Friday morning, although, as we will see later in this report, Coeuré, Constancio and Praet also have much to add.
“Monetary Policy: Past, Present and Future”. Speech by Mario Draghi, President of the ECB, at the Frankfurt European Banking Congress, 20 November 2015. I set forth, below, the key extracts from his speech, followed by my comments (emphasis mine):
“There are many reasons why asset purchases should have a strong impact on activity and inflation. Purchases compress yields and reduce the cost of financing in the economy through direct pass-through and portfolio rebalancing effects. For banks they make lending to the real economy more attractive than purchasing government bonds. Higher financial and real estate asset prices can also increase demand via wealth effects and lower the cost of equity for firms.”
- The ECB’s goal therefore is still to lower the interest rates on government borrowings in the eurozone and to push up stockmarket: Bullish Bund, peripherals and the Euro Stoxx.
“Even though low interest rates put pressure on banks‘ unit margins… the net impact of our measures on bank profitability is broadly neutral.”
- Low or negative interest rates are no longer considered to be a risk to banking sector profitability: one taboo less to justify a new lowering the deposit rate (-0.20%).
“Let me highlight three risks in particular which are relevant for that calibration.
First, the downside risks to our baseline scenario for the euro area economy have increased in recent months due to the deterioration of the external environment. … Second, even factoring in those headwinds, the strength of the underlying recovery is modest. … Third, the recovery remains very protracted in historical perspective. … If our current assessment is correct, it will take the euro area 31 quarters to return to its pre-crisis level of output – that is, in 2016 Q1.”
- A clearly negative bias with respect to the growth dynamic: further monetary easing required.
“We see subdued wage growth in the euro area, suggesting that the output gap is still exerting downward pressure on wages. The so-called core measures of inflation … have been hovering around 1% for nearly two years. … Low core inflation is not something we can be relaxed about, ….”
- His references to core inflation and wage growth represent another semantic shift toward the dual mandate of the Fed, which also argues for a further monetary easing.
“… APP to be a powerful and flexible instrument, as it can be adjusted in terms of size, composition or duration to achieve a more expansionary policy stance. The level of the deposit facility rate can also empower the transmission of APP, not least by increasing the velocity of circulation of bank reserves.”
- They will thus move first by adding to the existing QE, quantitatively and/or qualitatively. A lowering of the deposit facility rate would further improve the effectiveness of said QE.
- NB: It seems to me that his comment about the last phase involving the acceleration of the velocity of circulation of bank reserves is a reference to the totally discredited monetary multiplier theory! I can only hope that this turns out to be a matter of semantics, and that he was merely tipping his hat to the Austrian School proponents at the ECB.
“In making our assessment of the risks to price stability, we will not ignore the fact that inflation has already been low for some time. … we want to feel suitably confident that inflation will …stabilise around levels close to 2% over the relevant medium-term horizon.”
- The time is not really right to raise benchmark interest rates. Will Mr Draghi go so far as allowing a period to make up for inflation lag, by allowing inflation to settle above 2% for a certain period of time? In short, by allowing disguised price level targeting?
“we will do what we must to raise inflation as quickly as possible.”
- The positive reception Mr Draghi received for this morning’s “We will do what we must” recalls that following his celebrated “whatever it takes” statement in July 2012. Mr Draghi truly has a talent for coining phrases, but he already used this formulation just over a year ago during his speech before the same group, at the same place: “we will do what we must to raise inflation and inflation expectations as fast as possible”. Everything seems the same, except that this time we will not have to wait until January!
- Especially since it would appear, based on a reading of the minutes of the latest ECB Governing Council meeting held in Malta last October (released this week) that they were already on the verge of announcing a surprise.
- That speech served as the “quasi-announcement” of the programmes to be set up at the beginning of 2015. “Bis Repetita Non Placent”?
Of course, Mr Draghi does not decide all on his own, although he has not hesitated in the past to decide by majority vote in order to override objections from Germany in particular. We know that he seeks to form as wide a consensus as possible within the framework of the complex multilateral institution that is the European Central Bank.
So what can we derive from speeches of the other members of the ECB’s Governing Council? Among the core members of the governing council who count, lets start with Praet, Constancio, Coeuré, and Weidmann.
The other speeches
He is the last to have published a speech full of surprises, on 21 November, from which I provide, below, a few excerpts, which tend to deal more with fiscal than monetary policy and which look very much like rocks planted in the German balanced-budget garden, set to go into effect in 2016, in an increasingly mercantilist context!
“In an environment of low global growth, export-led strategies may be relevant for one economy, but in the aggregate they are bound to fail and they risk leading the global economy into a high saving, low real interest rate trap. There is in other words a fallacy of composition.” … “In other words, the model suggests that in a global ZLB environment, surplus countries can hold world output down, and even countries which in autarky would avoid falling in a liquidity trap may then be dragged down.” … “In economies that have sufficient fiscal space, it is indeed hard to see how fiscal expansions at the zero lower bound would not be a positive sum for the global economy.” … “It is high time that the growth narrative is shifted from a narrow view of “competitiveness” towards a broader understanding of “productivity”
The words above bear a strange resemblance to those used by Ben Bernanke when confronted with the pro-cyclical US government budget that hindered the economic recovery in the United States. In that case, he decided to step even harder the monetary gas pedal, by launching the QE2 and, later, QE3.
In fact, Benoit Coeuré made a direct reference to this matter on the 16th and 19th of November:
November 16: “I see no major distortions in the valuations of financial assets in the euro area.”
“Asset price distortions should in any case be addressed by macroprudential tools rather than through monetary policy.”
The purposes of the above comments is clearly to pre-empt the usual arguments of the ECB hawks (see Weidmann, below), who are always worried about the development of bubbles generated by overly accommodative monetary policies.
November 19: “The question we are asking ourselves is the following: are certain specific factors like the fall in commodity prices transitory? Or will they durably prevent the return of inflation towards 2%? If the answer to this second question is positive than additional measures will be taken”
“The decision has not been taken. The debate is open.”
“Whatever the Fed decides, whatever happens in the rest of the world, our monetary policy plan will keep interest rates low.”
The least we can say is that, without predicting what they will decide, his comments leave the door wide open to new measures, especially if we anticipate that the new forecasts to be presented by the ECB staff in December will confirm the effects of the worsening of the macroeconomic outlook on inflation in the framework of a horrible geopolitical context.
Clearly very close to the positions defended by Mario Draghi since he came to the helm, the ECB Vice President also spoke on 16 November in Frankfurt.
“The external environment of the euro area has deteriorated since the asset purchase programme began.”
“Concerns about growth prospects in emerging markets and unfavourable developments in financial and commodity markets have signalled downside risks to the outlook for growth and inflation, relative to the latest ECB staff projection from September.”
“Headline inflation is again at zero and core inflation has not consolidated a more positive development, which points to the need to reassess our policy stance in order to achieve our goals by 2017”
“Next to recent declines in oil prices, the combination of low inflation and low growth essentially points to a lack of demand holding back the recovery.”
“The euro area output is now 20% below the level it would have achieved had the trend growth of the previous 15 years continued after 2007. The crisis left a permanent economic loss with broad scars in our societies.”
- The above comments leave little doubt about the direction of the changes to be made December, nor Mr Constâncio’s willingness to respond in the most assertive many possible.
“Our assessment at present, monitoring a range of asset markets, is that there are no signs of generalised overvaluations in the euro area.”
- Here he pronounces the same phrase on the matter as Mr Coeuré, and I imagine with the same end in mind.
“Fiscal policy and to some extent, income policy, have room for manoeuvre whenever an economy is running a current account surplus. This is the case for the euro area that currently has a surplus of 3 percent of GDP and is projected to remain as such the next few years.”
- And like Mr Coeuré, he calls for a little boost from fiscal authorities to help the economy find the path to sufficient growth.
This new insistence by ECB Governing Board members (see also Mr Praet, below) on the demand part of the macroeconomic equation (although they never forget to add their little refrain on the need for structural reforms and supply policy) provides them even more room to intervene. After all, they consider that monetary actions can stimulate this demand. In any case, in the absence of help from the fiscal side, we are guaranteed years more of ultra-accommodative monetary policies.
The ECB’s chief economist since January 2012, this Belgian man with a German mother benefits from an indisputable capital of respect within the institution, and his comments must be closely scrutinised. He plays a pivotal role on the Governing Council, and any council member who wishes to oppose his views must rely on something other than simple ideological posturing. Here are the excerpts from his speech of 19 November, accompanied by some revealing slides, for the more curious among us. First, this is what he said, below, during an interview with Bloomberg Monday 16 November:
“In the recent past you had a supply-side issue, which is a windfall for consumers, but now a significant part is also coming from weak global conditions.”
- Again, this insistence on the demand side of the equation gives the ECB more freedom (as well as duty) to take action.
ECB members are not the only ones to make this point, since the BoE just asserted that:
“around two thirds of the fall in oil prices over the past six months can be accounted for by demand-related factors, such as concerns about weaker growth in countries such as China.”
Now let’s check out some of the key excerpts from Mr Praet’s speech of 19 November, along with the revealing slides I earlier promised to the more curious among us. What is essential is that uncertainty does not give rise to indecision. Indeed, even under uncertainty the ECB has always proven in the past that it is willing and able to react to any event – and that remains the case today. …The risks around the evolution of the global economy have shifted downward… Domestic demand, though rising, also appears relatively weak… this is the first cycle in modern times where real investment has not recovered its pre-crisis level after such a long period; it is in fact still 15% below… That mixed picture for activity feeds into greater uncertainty over the outlook for inflation. … Any potential action needs to be viewed in a context where the balance of risks to fulfilling our objective is on the downside…
At the same time, a central bank cannot allow itself too much discretion over the time horizon when inflation should return to its target…
Moreover, central banks know that if they lack a verifiable commitment to control inflation symmetrically …, this can result in inflation expectations becoming “unanchored”. It is in this spirit that a central bank may choose to proactively counter downside risks…monetary policy needs to remain sufficiently accommodative to offset any headwinds and produce a sustained adjustment in the path of inflation.
In particular, we have seen, on occasions, longer-term inflation expectations responding to short-term movements in oil prices. That is unacceptable for a central bank… Monetary policy can and must, however, anchor inflation expectations.
Well, there you have it. I think that, in view of the strength of his comments, I really don’t have much to add! Bear in mind that Mr Praet also emphasised the need for fiscal authorities to take actions that contribute to growth, in particular by re-launching investment. What we see here is a member of the central bank using polite language to the absurdity of European budgetary policy, especially German, in today macroeconomic context (ZLB, output gap, and deflation risk). The reaction of European authorities to the statements made by the French president before the special session of Parliament in Versailles, following the terrorist attacks in Paris (“the security pact” take precedence over the “stability pact”) is encouraging.
Mr Junker declared:
“France and other countries need additional means and these additional means should not be dealt with on the same footing as regular spending… For an extraordinary situation we need extraordinary spending. And it goes the same for other countries.”
That’s it for today.
I was hoping to scrutinise the comments made by Mr Weidmann last Friday 20 November before the same parliamentary session during which he addressed Mr Draghi, but I am afraid that making this already long report longer would make it unreadable to many. Besides, it no longer matters what he says! His speech was not even published on the ECB’s web site. You have to go on the Bundesbank website to find it…