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And then there were none. On Thursday, the European Central Bank became the last of the major central banks to announce a large programme of quantitative easing, involving the purchase of over €1tn of assets, mostly eurozone government bonds, in the next 18 months.
Is this the “credible regime change” which economists like Paul Krugman say is the only way that central banks can affect growth and inflation when interest rates have reached the zero lower bound? It would be too optimistic to say “yes”, but it is certainly a major philosophical shift by the conservative standards of the ECB. Originally designed slavishly on the Bundesbank model, the ECB has declared independence from its German forebears today.
But the long delays in reaching this point have made the eurozone deflation threat more severe than it need have been. Whether this belated recognition of reality is a case of better late than never, or too little too late, remains to be seen.
The markets are likely to assess the package with three litmus tests: is it big enough, are the restrictions placed on the bond purchases too restrictive, and does it matter that the decisions were far from unanimous, with the Bundesbank probably opposed to some key elements? In my view, the good clearly outweighs the bad. Read more
© Hannelore Foerster/Getty Images
The markets are waking up to the fact that the euro area faces a critical few weeks in which its economic path for 2015, and maybe for much longer, will be largely determined. Three inextricably linked events will dominate the economic landscape in January: the preliminary opinion of the Advocate General of the European Court of Justice (ECJ) on the legality of central bank bond purchases, due on January 14; the decision of the European Central Bank’s governing council on the size and type of “sovereign” quantitative easing (QE), due on January 22; and the Greek election on January 25.
At the optimistic end of the spectrum, the euro area might emerge with a more complete monetary framework that for the first time enables it to pursue monetary policy effectively at the zero lower bound for interest rates, and with the sanctity of the currency area reinforced. At the pessimistic end, the ECB could become shackled with an ineffective version of QE just when the euro area is officially entering outright deflation, and the single currency itself might become incompatible with political realities in Greece.
The outcome will also have much wider global implications. The markets have remained relatively relaxed about the likely exit of the Federal Reserve from its own zero interest rate policy in 2015, but only because the ECB and Bank of Japan are injecting more monetary stimulus. If large scale ECB action is removed from this equation, sentiment on global risk assets may darken considerably. Read more
Tuesday’s extremely weak German industrial production figures published for August have come an awkward time for the German government. An informal “employment conference” including some EU leaders has been called by Italian Prime Minister Renzi, and it is scheduled to take place, amid little advance publicity, in Milan on Wednesday. This will presumably set the stage for the next European Council meeting on October23. In between will be the International Monetary Fund/World Bank annual meetings in Washington, when the German approach to economic policy in the euro area will be heavily scrutinised.
The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both gross domestic product and inflation data are just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the eurozone: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the European Central Bank can bear fruit. 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
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 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
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
Based on the latest opinion polls, the Greek election could result in a highly confused outcome, with the new government being unable or unwilling to meet any budgetary terms acceptable to the Troika, but also unwilling to leave the euro voluntarily. What would happen then?
Economists like Thomas Mayer (Deutsche Bank) and Huw Pill (Goldman Sachs) have recently argued that, in these circumstances, Greece might resort to a “parallel” currency which would be used for some domestic transactions, while keeping the euro in place for existing bank deposits and for foreign transactions. Thomas is favourably disposed to the idea, while Huw foresees many problems with it.
Although I am not at all convinced that this would be a stable solution, since it might just be a prelude to much higher inflation in Greece, it is the kind of fudged development which can appeal to politicians. It could therefore have a part to play in the future of the eurozone. Anyway, it is destined to be widely discussed in coming weeks. Read more
A few weeks ago, I wrote that the twists and turns in the eurozone crisis had, in the early months of 2012, lost the power to shock global asset prices. The reason given was that the prophylactic provided by the use of the ECB’s balance sheet essentially trumped the deteriorating economic fundamentals in several countries, notably in Spain. This view has since been severely challenged, but it has just about remained intact; after all, American and Asian equities are still 6-7 per cent up so far this year.
However, the crisis which surrounds political events in Greece threatens to change all that. This is the first major revolt by any electorate against the eurozone’s austerity policies, and it is those policies which have underpinned the willingness of the ECB to use its balance sheet to rescue the banking system. Furthermore, Greece is just the tip of the iceberg. The swing against austerity by voters in the eurozone is manifesting itself in many different places. I have been wondering whether this is good or bad news for the resolution of the crisis. Read more
The UK GDP figures for 2012 Q1 are due to be published on Wednesday, and are likely to be followed by the usual out-pouring of angst about whether the economy is in a “technical” recession. This will clearly have important political connotations, but does not mean very much in a deeper economic context. The initial estimates for quarterly GDP are notoriously unreliable, and are no longer taken as the best estimate of UK economic activity even by the Bank of England.
No-one should read too much into the Q1 data, since the GDP outcome for the quarter is likely to be either slightly positive or slightly negative, depending on what happens in the construction sector. This volatile sector seems to have recorded a large drop in output in Q1, and since it represents 7.5 per cent of the economy, it is capable of being the swing factor which decides whether the Office for National Statistics prints a positive or negative GDP number for Q1. In the latter case, the media would probably scream “recession”, on the grounds that the economy would have experienced two back-to-back quarters of negative GDP growth.
In fact, most economists think that the figure will scrape into positive territory, but in any event no Chancellor deserves to be hanged on such flimsy grounds. Read more
In the second half of 2011, the twists and turns in the eurozone crisis dominated global markets to such an extent that nothing else seemed to matter. This remained true in January and February of this year, when the strong rally in peripheral bond spreads in the eurozone coincided with an equally strong rally in global equities. But in recent weeks, the umbilical link between the eurozone crisis and global risk assets seems to have broken down. As the graph shows, peripheral bond spreads (proxied by the average of Spanish and Italian spreads over German bunds) have returned towards crisis mode, while global equities have fallen only slightly. Read more
IMF Managing Director Christine Lagarde discusses global economic priorities at the Brookings Institution, April 12, 2012
The Spring Meetings of the IMF and the World Bank will be the focus of market attention this week. IMF Managing Director Christine Lagarde has set the ball rolling, with a speech calling for policy makers to “seize the day”. She is asking for a repeat of the “London moment” in February 2009, when G20 leaders announced a co-ordinated plan to rescue the global economy.
However, while her recommendations for action are perfectly sensible, there is an air of familiarity about them. They include a call for more financial resources for the IMF; delayed fiscal tightening in some countries, combined with longer term plans for budget consolidation; easy monetary policy in the developed economies; continued reform of the financial system; renewed labour market reforms; and measures to promote fairness and eradicate poverty. With no atmosphere of crisis surrounding the Spring Meetings, there seems little chance of anything dramatic emerging on any of these fronts this week. Read more
The wobble in risk assets in the past week has followed the Fed’s shift towards hawkishness, weaker US jobs data and the budget announcement in Spain. The fact that eurozone equities have once again underperformed US equities suggests that the Spanish budget was probably the dominant factor.
As the first graph shows, Spain’s sovereign bond yields and bank CDS spreads have recently widened to near their worst readings since the crisis started in 2010. What is even more worrying is the consistent upward trend which is apparent in the data. The eurozone rescue operation, mounted by the ECB and heads of government last December, reversed this deterioration only temporarily, and markets now seem to have resumed their earlier adverse trends. Everyone is asking whether this will trigger a new, and larger, eurozone crisis in 2012. Read more