The IMF on Tuesday repeated its call for the ECB to reduce policy rates in the eurozone, and Mario Draghi came fairly close to promising action in May at his press conference after the governing council meeting on April 4. But no-one really believes that the expected 0.25 percentage point cut in the main refinancing rate will do very much to solve the eurozone’s most pressing problem, which is the lack of bank lending to small and medium sized enterprises (SMEs) in the troubled economies.
Monetary conditions in the eurozone are fragmented. Bank lending rates are, perversely, much higher in the weakest economies than they are in the core. Unless this is solved, the eurozone economy will remain in trouble.
In order to address this issue, the ECB needs to think in ways which are unconventional, and therefore unpalatable for many of the conservatives on the governing council. However, both Mario Draghi and his colleague Benoît Cœuré have recently hinted that they view measures to eliminate fragmented lending rates as essential to fulfil the mandate of the ECB. This is how they justified the introduction of the Outright Monetary Transactions (OMT) programme, which saved the euro last autumn.
They have also said that the power of the ECB in this area is limited, and have argued repeatedly that effective action will require co-operation from member governments and from the European Investment Bank (EIB). It is therefore probable that discussions are under way between the ECB and member states to decide what can be done. There are two options which could have significant beneficial effects. Read more
Inflation targeting is dead, or so we are told with increasing frequency nowadays. Invented in the 1990s and widely propagated in the 2000s, targets for consumer price inflation failed to prevent the asset price bubble prior to 2008, or the subsequent financial collapse. Many investors now believe that inflation targets have been abandoned in all but name.
There is, however, a major problem with this line of argument. It does not tally with what the major central banks say they are actually trying to do, either in public or in private. Far from disappearing, inflation targets continue to gain prominence. Furthermore, they still play an essential role in ensuring good economic performance.
As recently as January 2012, the Federal Reserve formalised a 2 per cent inflation objective, while the Bank of Japan did the same for the first time only last month. The ECB continues to face heavy criticism because it pays such close attention to keeping inflation “below but close to” 2 per cent. Only the Bank of England can be seriously accused of downgrading its inflation objective in recent years, and even that may have changed in the past couple of MPC meetings. Read more
The eurozone is reluctant to admit formally that it is changing its austerity strategy, but in fact it is searching in every corner of national budgets to alleviate the squeeze on its troubled economies, and rightly so.
Recently, member states which have missed their budget targets (and that has been most of them) have been given more time to reach their objectives, implying less fiscal tightening in the near term. It is not all plain sailing, as Portugal’s latest tribulations demonstrate, but the eurozone has recognised that it should not be piling even more short term fiscal contraction on declining economies. It is reported today that the troika will suggest that the average duration of official loans to Ireland and Portugal should be extended by seven years at a meeting of EU finance ministers on April 12-13. Read more
Global activity data have softened recently, especially in the US, which had previously been the one obviously bright spot in a generally bleak landscape. The US employment report for March was weak across the board, and the latest batch of business surveys suggests that the strong momentum which was apparent in the early part of the year has dissipated. Meanwhile, although China is expanding again, the eurozone has failed to maintain the signs of stabilisation which were visible earlier in the year. Even the German economy seems to be stalling, which could prove pivotal.
The American stockmarket not yet paid much attention to the weaker data, though global equities are actually no higher than the levels reached at the end of January. The next major leg up in equities may need to wait until it becomes clear whether the world economy is simply suffering from another of the mid year weak patches which have characterised the past 3 years, or is suffering from something more serious this time. Read more
The package of quantitative easing announced today by the new regime at the Bank of Japan is one of the largest monetary injections ever announced by the central bank of a major developed economy. The only rival for that crown is the emergency easing in monetary policy which took place in most economies in late 2008. But today’s BoJ action has not been driven by any short-term emergency. It represents a deliberate change in philosophy, and a complete abandonment of everything that the Bank of Japan has said about monetary policy in the past two decades. Those who believe in quantitative easing certainly have their experiment, writ large in Tokyo.
In effect the new governor, Haruhiko Kuroda, has imported into Japan the whole of the Federal Reserve’s post-Lehman balance sheet strategy, and he will implement it in under two years, instead of the five years or more taken by the Fed. The doubling in the Japanese monetary base over a period of 21 months is in itself remarkable. Taken together with the extension of the duration of bonds purchased from less than 3 years to an average of 7 years, the injection becomes of historic proportions.
The new strategy brings, for the first time, a real prospect of breaking the deflationary psyche which has plagued Japan for so long. But it also brings risks that the strategy might work too well, with inflation expectations unhinging the bond market. Mr Kuroda is trying to pull off a difficult trick, which is “to drastically change the expectations of markets and economic entities”, and to do so in a very particular way. Read more
The main elements in the resolution of the Cyprus crisis have clarified this weekend. Although there are many specifics still be be settled, it appears that large depositors in the Bank of Cyprus are likely to lose 40-60 per cent of their original worth, while those in the Laiki Bank will probably lose almost all of their money.
Most observers agree that this second attempt at a resolution is highly preferable to the first, largely because it avoids imposing losses on small scale deposit holders (under E100,000, which are intended to be “insured” under the eurozone’s future bank insurance regimes). However, the brutal losses imposed on large depositors this weekend will come as a shock. And all those with money in Cyprus now face severely impaired liquidity because of draconian capital controls. Read more
The calmness of the financial markets in the face of the deteriorating Cyprus crisis in the past week has been remarkable. Although Cyprus is tiny enough to be completely overlooked in most circumstances, its economy and banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital and reliance on foreign funding, is familiar territory in the eurozone.
Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis, if a microcosm on steroids. The manner in which the crisis has been handled by the Eurogroup and the ECB will have demonstration effects on other economies, for good or ill.
At the time of writing, the outcome of this weekend’s negotiations remains uncertain. However, assuming that there is no catastrophic breakdown in the talks, leading to the exit of Cyprus from the euro area, the broad outline of the settlement seems to be taking shape. It is reported that the Cypriot government will accept a “bail in” of depositors in one or both of its troubled banks, allowing the release of eurozone financial support, while still keeping the government debt/GDP ratio under 150 per cent. Read more
Predictably, the chancellor has rejected calls for a radical change in his economic strategy. Plan A has not morphed into Plan B. If anything, it has become Plan A-plus, with the underlying path for fiscal tightening left unchanged, and a little more flexibility for the Bank of England to pursue unconventional monetary stimulus.
UK real GDP is still stuck some 5 per cent below its pre-crisis level, the worst record among the major economies, apart from Italy. Some of this is certainly due to the problems which the Coalition inherited. However, about half of the shortfall in UK growth in recent years, compared to that in the US, is due to the tightening of 5 per cent of GDP in fiscal policy since 2009/10.
The dominant criticism of the government from mainstream economists is, of course, that the poor performance of UK GDP is due to a shortfall in aggregate demand, which in turn is primarily due to these fiscal measures. The Chancellor’s reply is that the UK could have faced a fiscal crisis without his budgets. The fact that public debt is now forecast to rise to 85 per cent of GDP in 2017/18 suggests that his concerns are not easy to dismiss as scare-mongering. Read more
The FOMC will meet on Wednesday with the markets feeling confident that there will be no change in monetary policy. This means that the $85bn per month rate of balance sheet expansion will probably remain in place. But recently chairman Ben Bernanke has conceded, rather reluctantly, that the Fed’s exit strategy from quantitative easing will soon need to be reconsidered by the committee, and the debate could start at this month’s meeting. In any event, with economists now upgrading their forecasts for US GDP for the first time in quite a while, the markets are increasingly focused on whether the exit can be handled successfully.
The first question is whether the exit will be gradual or abrupt. The chairman’s personal preference is very well known: it should be gradual, and extremely well flagged in advance. But Mr Bernanke might not be in office after next January, and there are others on the FOMC who could have different ideas. Furthermore, economic and market circumstances could change. In 1994, GDP growth and inflation both rose markedly, and the Fed slammed on the brakes without any warning. The resulting 3 per cent rise in the Fed funds rate delivered a major shock to the financial system. Read more
The sterling exchange rate has now declined by about 7 per cent this year, thus eliminating all of the rise which occurred when the euro crisis was in full flood in 2011-12. Investors are asking three main questions about the drop in sterling. When will it end? Will it succeed in boosting UK economic growth? And could it, conceivably, lead to a full blown sterling crisis? Read more