Time for the ECB to get serious about the overvalued euro

The euro has become a currency on steroids.  Its relentless nominal and real appreciation since the end of 2000 was briefly interrupted in the second half of 2008, but resumed with a vengeance during 2009.  The strength of the currency is hurting the exporting and import-competing sectors of the Euro Area.  Unemployment and excess capacity continue to rise.  The euro’s excessive strength is also contributing to a significant and persistent undershooting of the rate of inflation the ECB deems to be consistent with price stability in the medium term: headline HICP inflation in December 2008 was 1.60 percent in December 2008, hit zero in May 2009 and has been negative since then.

The next two tables demonstrate the relentless climb of the euro since 2001.  The narrow effective exchange rate is for the euro 11-16 nations and involves a trade-weighted average of 12 bilateral exchange rates vis-a-vis the euro.  The CPI measure for the real exchange rate is used. Prior to 1999 (the start of the euro), a synthetic euro-index is used.  Data are from Eurostat.

The broad effective exchange rates are for the euro-16 nations, and involve a trade-weighted average of 41 bilateral exchange rates.  The CPI measure of the real exchange rate is used.  Data are from Eurostat.

What accounts for the strength of this über-currency? The profession’s inability to understand, let alone predict, things monetary is amplified when it comes to explaining or predicting the relative price of (at least) two currencies. Nevertheless, any disinterested observer would be hard-pushed to avoid the conclusion that the Eurozone is paying the price for the ECB’s excessively tight monetary policy.

The ECB’s monetary policy is excessively tight in relation to the ECB’s self-imposed quantitative expression of its Treaty-based price stability mandate.  In the ECB’s own words: “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

There is no doubt in my view that the ECB has an asymmetric interpretation of its price stability mandate. Excessive inflation is to be avoided at all cost.  However, excessive deflation can be tolerated and rationalized.

The ECB’s monetary policy stance is also excessively tight in relation to the monetary policy stances of the other advanced industrial countries, especially those in the US, Japan and the UK.  By keeping the official policy rate at 1.00 percent, while the corresponding rates are 0 to 0.25 percent for the US, 0.50 percent for the UK and 0.10 percent for Japan, the ECB has constructed a tailor made intra-advanced-industrial-countries carry-trade vehicle.

Can the ECB pay attention to the exchange rate, beyond what the behaviour of the exchange rate implies for price stability in the medium term?  Of course it can.  It is indeed mandated to do so.  Just because price stability is the primary objective of the ECB, taking pole position in a lexicographic ordering of central bank objectives, does not mean that the ECB can afford to ignore other objectives, as long as their pursuit does not prejudice the price stability objective.  The Treaty is very clear on this.

Article 105 of the Treaty Establishing the European Community states: “The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4.”

Article 2 reads: “The Community shall have as its task, by establishing a common market and an economic and monetary union and by implementing common policies or activities referred to in Articles 3 and 4, to promote throughout the Community a harmonious, balanced and sustainable development of economic activities, a high level of employment and of social protection, equality between men and women, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance, a high level of protection and improvement of the quality of the environment, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among Member States.”

The relevant bit of Article 4 reads: “2. Concurrently with the foregoing, and as provided in this Treaty and in accordance with the timetable and the procedures set out therein, these activities shall include the irrevocable fixing of exchange rates leading to the introduction of a single currency, the ecu, and the definition and conduct of a single monetary policy and exchange-rate policy the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Community, in accordance with the principle of an open market economy with free competition”.

Even through the ECB may have limited scope for promoting equality between men and women through its monetary and exchange rate policies (it can do so, of course, through its hiring and promotion policies), it can, at times, pursue a high level of employment by targeting a more competitive exchange rate, without in doing to undermining its primary objective, price stability.  Indeed, under present conditions, the ECB is undermining its price stability objective by passively twiddling its thumbs while the euro appreciates.

The deflationist bias of the ECB

The asymmetry in the response of the ECB to inflation rates above the level deemed consistent with price stability in the medium term, as opposed to inflation rates below that level is staggering and poses a material risk to the independence of the institution.  When headline HICP inflation rose above the tolerance level of ‘below but close to two percent’ during 2005 and the first three quarters of 2006, and from the last quarter of 2007 till almost the end of 2008, the ECB emphasized the threat posed by the headline inflation rate and poo-pooed the relevance of the much lower core inflation rate (core inflation is HICP inflation net of the energy, food, tobacco and alcohol components).

The table below shows the divergent behaviour of the headline and core HICP indices during those periods, as well as during the period since the very end of 2008, when the relationship between headline and core inflation in the Euro Area was reversed, with headline inflation significantly below core inflation.

The ECB rightly warned against deriving too much comfort from a  core inflation rate that was still in the comfort zone while the headline inflation was well above the tolerance level.  For instance, in the
ECB statement on December 1, 2005, Jean-Claude Trichet stated that: “In interpreting current inflation rates, it is important to make a clear distinction between temporary, short-term factors, on the one hand, and factors of a more lasting nature, on the other. In that respect, it is of crucial importance to take a strictly forward-looking perspective, which does not allow much comfort to be drawn from the current, comparatively lower rates for measures of inflation that exclude certain components, such as energy or certain categories of food. Such measures of “core” inflation have, at least in the past, been shown to lag behind, rather than lead, the developments in headline inflation.”

President Trichet was absolutely correct: temporary vs permanent need bear no relation at all to non-core vs. core. To assume that core = permanent and non-core = transitory, as was common practice among Federal Reserve Board members and Fed research staff until quite recently, is bad economics and bad statistics.  I have argued this at some length in earlier posts (e.g. (1) and (4)).

However, this explosion of good sense did not survive the onset of a period of excessively low headline inflation.  The latest (October 2009) edition of the ECB’s Montly Bulletin states (in Box 3, page 39) that “at the current juncture, it is particularly insightful to look at the less volatile components of the HICP in order to analyse the forces driving inflation.” And guess what, the less volatile components of the HICP are the core components.

To a disinterested observer like myself, this suggest strongly that the ECB is talking out of both sides of its mouth and that it speaks with a forked tongue when it insists it has a symmetric interpretation and implementation of its price stability mandate.  Clearly it is more concerned about inflation than about deflation.  It is in violation of its mandate.

What is to be done?

The ECB is violating its price stability mandate by tolerating, aiding and abetting deflation in the Euro Area.  It has the option of cutting the official policy rate by at least 100 basis points, but chooses not to exercise this option.  It should cut the official policy rate (the Main refinancing operations (fixed rate)) from 1.00 percent to 0.00 percent, and the interest rate on the deposit facility (reserves held by commercial banks with the Eurosystem) from 0.25 percent to minus 0.75 percent.  To those who argue that euro currency sets a zero lower bound to all short nominal interest rates, I recommend a reality check: do they really believe that Euro Area commercial banks would stockpile euro notes in large warehouses rather than holding deposits with the Eurosystem if the spread between the interest rate on deposits with the Eurosystem and the (zero) interest rate on euro currency were minus 75 basis points?

Perhaps the banks might consider a switch from reserves with the central bank to euro currency if the ECB’s deposit rate were set at minus 5 percent or minus ten percent.  Even then, the negative nominal interest rate on deposits could be enforced if the ECB were to abandon the fixed exchange rate between euro deposits and euro currency: a minus ten percent interest rate on euro deposits with the Eurosystem would amount to the same pecuniary return as a zero percent interest rate on euro currency if the ECB were to announce and implement a ten percent appreciation of euro deposits vis-a-vis euro currency.  But none of that is necessary when the official policy rate is at zero and the deposit rate at minus 75 basis points.

Coordinated foreign exchange market intervention

The exchange rate, when it is not market-determined (floating) is not an instrument that is managed solely at the discretion of the ECB.  Even when it is market-determined, policy actions implemented by the ECB that may influence the external value of the currency are not determined solely by the ECB.  The exchange rate is a joint competency of the ECB and the Council of Ministers.  Articles 105 and  111 of the Treaty (Consolidated Version) are clear on this.

Article 105 states that the ECB will implement foreign exchange market interventions:

“105.2. The basic tasks to be carried out through the ESCB shall be:
— to define and implement the monetary policy of the Community,
— to conduct foreign-exchange operations consistent with the provisions of Article 111,
— to hold and manage the official foreign reserves of the Member States,
— to promote the smooth operation of payment systems. “

Though the ECB implements any foreign exchange market intervention that has been decided upon, whether to intervene or not, and in what manner, is not decided by the ECB alone, as is clear from Article 111:

Article 111
1. By way of derogation from Article 300, the Council may, acting unanimously on  a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, after consulting the European Parliament, in accordance with the procedure in paragraph 3 for determining the arrangements, conclude formal agreements on an exchange-rate system for the ecu in relation to non-Community currencies. The Council may, acting by a qualified majority on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, adopt, adjust or abandon the central rates of the ecu within the exchange-rate system. The President of the Council shall inform the European Parliament of the adoption, adjustment or abandonment of the ecu central rates.

2. In the absence of an exchange-rate system in relation to one or more non-Community currencies as referred to in paragraph 1, the Council, acting by a qualified majority either on a recommendation from the Commission and after consulting the ECB or on a recommendation from the ECB, may formulate general orientations for exchange-rate policy in relation to these
currencies. These general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability.”
(Article 300 can be found here; it doesn’t add much.)

I happen to be rather sceptical about the effectiveness of sterilised foreign exchange market intervention in a world with a very high degree of international capital mobility.  But even it does not help, it is unlikely to hurt.  For the first time in as long as I can remember, President Trichet has hinted openly at the possibility of coordinated foreign exchange market intervention.  In the Q&A following the October ECB Governing Council meeting, he stated “As regards your question on the dollar and the euro, I would say that where the floating currencies, the major floating currencies, are concerned, we, the Governing Council of the ECB, believe that excess volatility and disorderly movements in exchange rates have adverse implications for economic and for financial stability. And, as you know, we are in agreement in this respect on both sides of the Atlantic. We will continue to monitor the exchange markets closely and cooperate as appropriate. I would also say that I trust that the statement of the US authorities on the strong-dollar policy is extremely important in the present circumstances. When the Secretary of the Treasury and our friend Ben Bernanke say that a strong dollar is in the interests of the US economy and that they are pursuing a strong-dollar policy, this is a judgement that is obviously very important for us and for the global economy.” (emphasis added).

Cooperation here means only one thing, and it isn’t coordinated prayer. But even if President Trichet were opposed to intervention, or if the majority on the Governing Council were, now would be the time for the Council of Ministers to ”formulate general orientations for exchange-rate policy ” as per articles 105 and 111, and to instruct the ECB to intervene to stop any further rise of the euro and preferably to bring it down.

Obviously, “These general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability.” , but that would not be an issue under current economic circumstances when price stability is violated in a downward direction.  A 15 or 20 percent depreciation of the effective exchange rate of the euro would not threaten the price stability mandate, it would help achieve it.

Incidentally, the Treaty says nothing as to who will be the judge of whether a general orientation concerning exchange rates is “without prejudice to the primary objective of the ESCB to maintain price stability.” The ECB views itself as the natural guardian of price stability, but the Treaty leaves this open, no doubt reflecting an uneasy compromise between those involved in its writing.

What hope is there of the other central banks that matter (the Fed, the Bank of Japan, the People’s Bank of China and the Bank of England) joining in a coordinated intervention to bring down the euro?  Unless the intervention is coordinated, it will not even be worth trying.

As regards the PBC, the odds are zero. Without the ECB throwing in a sweetener, the odds on the Fed, the Bank of Japan and the Bank of England intervening jointly are lower than that of the governors of the four institutions jointly participating in a public broadcast of a Pilates class.  The US fiscal and monetary policy makers may pay public lipservice to the strong dollar, but they thank the good Lord in private every time the dollar weakens.  The chairman of the Fed, the US Treasury Secretary and the big fellow in the NEC all would like to see the US dollar weaker, as long as dollar weakening does not become a disorderly rout that threatens to raise US longer-term interest rates.

The Bank of Japan and the Japanese ministry of finance want to see a weaker yen, not a stronger yen.  In the UK, the governor of the Bank of England has been actively talking down the pound sterling.  The fact that there still is a UK economy, after more that a decade of overvaluation of sterling and intersectoral misallocation of resources, is in no small part due to the weakness of sterling this past year.

So if president Trichet wanted to orchestrate a coordinated intervention to bring down the euro (or if he were to receive a general exchange rate orientation from the Council of Ministers to that effect), he would find no takers unless he had something to offer.  And he does.  He has 100 basis points to play with off the official policy rate, and a similar amount off the interest rate on deposits.

Even if the instinctively cautious ECB were to implement just a 50 bps cut in the Main refinancing operations (fixed rate) and in the rate on the Deposit facility, to complement a coordinated foreign exchange market intervention to weaken the euro, this would enhance the odds that the  intervention would be effective.  There was a coordinated intervention by the ECB, the Fed, the Bank of Japan and the Bank of England to strengthen the euro on 22 September 2000, but without any complementary change in official policy rates.  It was a mixed success at best.  A unilateral intervention by the ECB to strengthen the euro followed on November 3, 2000; it was a failure.

The coordinated interventions following the 9/11 attacks in 2001 were sui generis; they had no normal monetary or exchange rate policy objectives but were aimed at maintaining orderly markets and access to US$, euro and other liquidity worldwide following the terrorist outrages.  The mutual extension of swap lines were spectacularly successfull, of course.  On November 8 and November 18,  2004, president Trichet engaged in open mouth operations aimed at weakening the euro, whose steep rise he described as “brutal”. These verbal interventions were subject to diminishing marginal productivity.

By proposing a coordinated intervention to bring down the euro (presumably combined with coordinated open-mouth operations by the central bank governors involved) supplemented with, say, a 50 basis points rate cut for the Euro Area, the ECB would render ineffective the obvious US and Japanese rejoinder to a request for joint intervention to weaken the euro: “you have unused ammunition in your arsenal – 100 basis points worth of potential interest rate cuts for the official policy rate and the rate on deposits; use that first, before you come calling for external assistance.”

It is time for the ECB to demonstrate that, despite all the evidence of recent years, it does not pursue an asymmetric, deflationist monetary agenda, but that it takes a violation of its price stability mandate in a downward direction equally seriously as a deviation in an upward direction.   If the ECB persists in acting in a willfully asymmetric manner, its cherished independence will be taken from it.  The letter of the Treaty will provide no protection against popular anger and political opportunism.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website