For many years, one of the most enduring mantras of central banking was along the lines of “we never pre-commit to future actions, because all of the information we have about the state of the economy is already contained in the actions we have just announced”. Now that has been completely abandoned. With the ECB and the BoE changes announced today, the central banks are shouting from the rooftops that “we are all forward guiders now”.
In the old days, if the central banks wanted to ease or tighten policy, they just adjusted the size of the change in interest rates at any given meeting, and allowed their actions to speak for themselves. The forward path for short rates was generally very sensitive to any given change in the policy rate, so they did not have to worry too much about the impact of their policy on the yield curve. Read more
The ECB decided yesterday against “going negative” by reducing its deposit rate from zero to -0.25 per cent. The Governing Council again debated the pros and cons of such a measure, which would represent the first time that any of the major four central banks would ever have reduced a key policy rate to below zero . Mr Draghi said again that the ECB was “technically ready” to take this action, and that the option remains “on the shelf”.
Many in the markets believe that this is just a bluff to prevent the euro from rising in the foreign exchange markets. There have been several unsupportive comments from leading members of the Governing Council (Asmussen, Mersch, Noyer and Nowotny) and Mr Draghi admitted that disagreements exist in the Council. Nevertheless, the President has deliberately left the option on the table, so it is important to understand the debate.
The technical aspects of negative rates have been very well covered in FT Alphaville recently, but I would like to focus on the broader policy implications. Why would a central bank want to take this action, and could it back-fire on them? Read more
Fiscal austerity, a concept which German Chancellor Merkel says meant nothing to her before the crisis, may have passed its heyday in the eurozone. This week, the European Commission has published its country-specific recommendations, containing fiscal plans for member states that are subject to excessive deficit procedures. These plans, which will form the basis for political discussion at the next Summit on 27-28 June, allow for greater flexibility in reaching budget targets for several countries, including France, Spain, the Netherlands and Portugal.
Furthermore, there have been rumblings in the German press suggesting that Berlin is beginning to recognise that fiscal consolidation without economic growth could prove to be a Pyrrhic victory. If true, this could mark the beginning of a new approach in the eurozone, helping the weakest region in the global economy to recover from a recession that has already dragged on far too long. So how real is the prospect of change? Read more
Martin Wolf’s column on Wednesday and his subsequent blogpost have once again focused attention on the importance of trade flows in the eurozone. Martin’s argument is that the German strategy of fiscal austerity and internal reform to fix the imbalances needs to change. I would like to ask a different question, which is what happens in the likely event that it does not change?
Investors, ever more optimistic that the worst of the euro crisis is over, are asking whether the German strategy might actually work. Largely unnoticed by some, eurozone trade imbalances have in fact improved dramatically in recent years. But this has happened mainly for the wrong reasons, ie recession in the south rather than any large narrowing in the competitiveness gap. The eurozone is engaged in a race between the gradual pace of internal devaluation and the mercurial nature of democratic politics. It is still not obvious how this race will end.
When the euro was launched in 1999, its supporters believed that the balance of payments crises which had plagued its weaker members for decades would become a relic of the past. The crisis revealed this view to be entirely complacent. The current account imbalances which were generated by the peripheral economies during the boom of the 2000s soon became impossible to finance after the crash. It was only the growth of so-called “Target2″ imbalances on the ECB’s balance sheet which provided the official financing which held the system together. No Target2, no euro.
However, some of the contingent credits which the Bundesbank has acquired against the rest of the ECB in the course of this process might become worthless under certain break-up scenarios, and this has become a political hot potato inside Germany. The solution, many in Germany believe, is to foster an improvement in the balance of payments positions of the troubled economies so that no further rise in the Target2 imbalances will be needed. Read more
Market expectations about Thursday’s ECB meeting had become quite bullish in the past couple of weeks (see this blog), and Mr Draghi went just far enough to justify those expectations by cutting the main repo rate by 0.25 per cent and the marginal lending rate by 0.5 per cent. This is a clever way of directing more help to those banks which need it most in the south.
Adding to his dovish tone, he talked about cutting deposit rates at the ECB into negative territory, as Denmark has already done (with moderate success), and he hinted that the ECB still has one further repo rate cut in the locker. At the less dovish end of the spectrum, he said that the ECB will not buy government bonds, which does not sound promising for Fed-style QE, should the eurozone economy continue to weaken. Read more
The recent rise in eurozone equities, along with a sharp further decline in peripheral bond spreads, has occurred in the face of continuing disappointing data on economic activity. Real GDP in the eurozone seems to be declining at a 2 per cent annualised rate in the current quarter, and the pivotal German economy is showing worrying signs of being dragged into the mire with the troubled south (see this earlier blog).
Markets are in one of those periods (which usually prove temporary) where they interpret bad economic news as being good news for asset prices, because weaker growth will result in easier policy from the central banks. In the eurozone, expectations are high that the European Central Bank will deliver lower interest rates on Thursday, and specific measures designed to address the provision of liquidity to small and medium sized enterprises (SMEs) in the south seem probable.
But a more radical easing in monetary conditions may prove necessary to drag the economy out of recession, and prevent inflation from falling further below the target, which is defined as “below but close to 2 per cent”. In March, the ECB staff forecast for inflation in 2014 was 0.6-2.0 per cent, which seems barely consistent with the mandate, especially as the recession shows no sign of ending and fiscal policy is still being tightened. Any other major central bank would be urgently reviewing its options for aggressive easing, and the markets could become very disillusioned if they sense that the ECB is unwilling to do the same.
So what, realistically, can the ECB do? The following table gives a fairly comprehensive list of the options which are definitely available within the mandate [A], those which might be available if the ECB chose to interpret its mandate more widely [B], and those which are clearly unavailable under any circumstances [C]:
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
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
When David Marsh wrote his definitive biography of the Bundesbank in 1993, he chose the following sub title: “The Bank That Rules Europe“. Feared and revered in equal measure, the Bundesbank was the model on which the ECB was built. Imitation was not, however, the sincerest form of flattery for Germany’s central bank. The arrival of the ECB removed most of its direct authority over monetary policy, leaving it with only one out of 23 votes on the governing council of the new central bank.
Recently, the Bundesbank’s President Jens Weidmann has been in a minority of one on the question of whether to launch the ECB’s new programme of Outright Monetary Transactions, to which he is fundamentally opposed. He views the proposed purchases of government debt in the troubled eurozone economies as a thinly disguised monetary bail-out of profligate governments, something which the Bundesbank had believed from the very beginning to be outside the intention of the treaties. Read more
Today’s decision from the German Constitutional Court in Karlsruhe is a major victory for Angela Merkel and for Germany’s preferred approach to handling the eurozone crisis. The court has approved the ratification of the ESM treaty, with only minor conditions attached.
It looks like a comprehensive defeat for those trying to mobilise political opinion inside Germany to block the treaty. As a result, the ESM and the fiscal compact can now be safely launched, and any immediate obstacle to Mario Draghi’s bond buying plan at the ECB has disappeared. What has emerged from this messy process is, in effect, an ESM leveraged by the ECB, something which seemed impossible this spring.
This represents a very large building block in the rescue strategy which the eurozone has gradually pieced together in the last three months.
The acute phase of the crisis peaked in mid June with the Greek election, which reduced the probability of a disorderly Greek exit.
Then, the eurozone summit in late June announced a roadmap for the long term reform of the eurozone. Mr Draghi was a co-author of the plan, and in retrospect it was a very important step, not least because he deemed it to be so.
These steps did not immediately settle the markets, and at times during July it seemed that the capital outflow from Spain would reach unmanageable proportions. However, at that point, Mr Draghi crucially said that the ECB considered it to be within its mandate to eliminate “convertibility risks” in the eurozone, and that statement basically turned the crisis around. Since then, for example, Spanish equities have risen by 30 per cent. Read more