Archive for the ‘Monetary Policy’ Category

ECB: Great Expectations

June 5, 2014 3 comments

After the latest disappointing data on growth and indeflation in the Eurozone, all eyes are on today’s ECB meeting. Politicians and commentators speculate about the shape that QE, Eurozone edition, will take. A bold move to contrast lowflation would be welcome news, but a close look at the data suggests that the messianic expectation of the next “whatever it takes” may be misplaced.

Faced with mounting deflationary pressures, policy makers rely on the probable loosening of the monetary stance. While necessary and welcome, such loosening may not allow embarking the Eurozone on a robust growth path. The April 2014 ECB survey on bank lending confirms that, since 2011, demand for credit has been stagnant at least as much as credit conditions have been tight. Easing monetary policy may increase the supply for credit, but as long as demand remains anemic, the transmission of monetary policy to the real economy will remain limited. Since the beginning of the crisis, central banks (including the ECB) have been very effective in preventing the meltdown of the financial sector. The ECB was also pivotal, with the OMT, in providing an insurance mechanism for troubled sovereigns in 2012. But the impact of monetary policy on growth, on both sides of the Atlantic, is more controversial. This should not be a surprise, as balance sheet recessions increase the propensity to hoard of households, firms and financial institutions. We know since Keynes that in a liquidity trap monetary policy loses traction. Today, a depressed economy, stagnant income, high unemployment, uncertainty about the future, all contribute to compress private spending and demand for credit across the Eurozone, while they increase the appetite for liquidity. At the end of 2013, private spending in consumption and investment was 7% lower than in 2008 (a figure that reaches a staggering 18% for peripheral countries). Granted, radical ECB moves, like announcing a higher inflation target, could have an impact on expectations, and trigger increased spending; but these are politically unfeasible. It is not improbable, therefore, that a “simple” quantitative easing program may amount to pushing on a string. The ECB had already accomplished half a miracle, stretching its mandate to become de facto a Lender of Last Resort, and defusing speculation. It can’t be asked to do much more than this.

While monetary policy is given almost obsessive attention, there is virtually no discussion about the instrument that in a liquidity trap should be given priority: fiscal policy. The main task of countercyclical fiscal policy should be to step in to sustain economic activity when, for whatever reason, private spending falters. This is what happened in 2009, before the hasty and disastrous fiscal stance reversal that followed the Greek crisis. The result of austerity is that while in every single year since 2009 the output gap was negative, discretionary policy (defined as change in government deficit net of cyclical factors and interest payment) was restrictive. In truth, a similar pattern can be observed in the US, where nevertheless private spending recovered and hence sustained fiscal expansion was less needed. Only in Japan, fiscal policy was frankly countercyclical in the past five years.

As Larry Summers recently argued, with interest rates at all times low, the expected return of investment in infrastructures for the United States is particularly high. This is even truer for the Eurozone where, with debt at 92%, sustainability is a non-issue. Ideally the EMU should launch a vast public investment plan, for example in energetic transition projects, jointly financed by some sort of Eurobond. This is not going to happen for the opposition of Germany and a handful of other countries. A second best solution would then be for a group of countries to jointly announce that the next national budget laws will contain important (and coordinated) investment provisions , and therefore temporarily break the 3% deficit limit. France and Italy, which lately have been vocal in asking for a change in European policies, should open the way and federate as many other governments as possible. Public investment seems the only way to reverse the fiscal stance and move the Eurozone economy away from the lowflation trap. It is safe to bet that even financial markets, faced with bold action by a large number of countries, would be ready to accept a temporary deterioration of public finances in exchange for the prospects of that robust recovery that eluded the Eurozone economy since 2008. A change in fiscal policy, more than further action by the ECB, would be the real game changer for the EMU. But unfortunately, fiscal policy has become a ghost. A ghost that is haunting Europe…

Wrong Debates

May 9, 2014 1 comment

Paul Krugman has a short post on the Eurozone, today (I’d like him to write more about us; he has been too America-centered lately), pointing out that the myth of fiscal profligacy is, well, just a myth. in fact, he argues, the only fiscally irresponsible country, in the years 2000 was Greece. It is maybe worth reposting here a figure that from an old piece of this blog, that since then made it into all my classes on the Euro crisis: Fig1PostMArch16
The figure shows the situation of public finances in 2007, against the Maastricht benchmark (3% deficit and 60% debt) before the crisis hit. As Krugman says, only one country of the so-called PIIGS  (the red dots) is clearly out of line, Greece. Portugal is virtually like France, and Spain and Ireland way better than most countries, including Germany. Italy has a stock of old debt, but its deficit in 2007 is under control.

So Krugman is right in reminding us that fiscal policy per se was not a problem before the crisis; And yet, what he calls fiscal myths, have shaped policies in the EMU, with a disproportionate emphasis on austerity. And even today, when economists overwhelmingly discuss unconventional measures available to the ECB to contrast deflation, fiscal policy is virtually absent from the debate and continued fiscal consolidation is taken for granted. I will write more on this in the next days, but it is striking how we aim at the wrong target.

ECB: One Size Fits None

March 31, 2014 18 comments

Eurostat just released its flash estimate for inflation in the Eurozone: 0.5% headline, and 0.8% core. We now await comments from ECB officials, ahead of next Thursday’s meeting, saying that everything is under control.

Just this morning, Wolfgang Münchau in the Financial Times rightly said that EU central bankers should talk less and act more. Münchau also argues that quantitative easing is the only option. A bold one, I would add in light of todays’ deflation inflation data. Just a few months ago, in September 2013, Bruegel estimated the ECB interest rate to be broadly in line with Eurozone average macroeconomic conditions (though, interestingly, they also highlighted that it was unfit to most countries taken individually).

In just a few months, things changed drastically. While unemployment remained more or less constant since last July, inflation kept decelerating until today’s very worrisome levels. I very quickly extended the Bruegel exercise to encompass the latest data (they stopped at July 2013). I computed the target rate as they do as


(if you don’t like the choice of parameters, go ask the Bruegel guys. I have no problem with these). The computation gives the following:


Using headline inflation, as the ECB often claims to be doing, would of course give even lower target rates. As official data on unemployment stop at January 2014, the two last points are computed with alternative hypotheses of unemployment: either at its January rate (12.6%) or at the average 2013 rate (12%). But these are just details…

So, in addition to being unfit for individual countries, the ECB stance is now unfit to the Eurozone as a whole. And of course, a negative target rate can only mean, as Münchau forcefully argues, that the ECB needs to get its act together and put together a credible and significant quantitative easing program.

Two more remarks:

  • A minor one (back of  the envelope) remark is that given a core inflation level of 0.8%, the current ECB rate of 0.25%, is compatible with an unemployment gap of 1.95%. Meaning that the current ECB rate would be appropriate if natural/structural unemployment was 10.65% (for the calculation above I took the value of 9.1% from the OECD), or if current unemployment was 11.5%.
  • The second, somewhat related but more important to my sense, is that it is hard to accept as “natural” an unemployment rate of 9-10%. If the target unemployment rate were at 6-7%, everything we read and discuss on the ECB excessively restrictive stance would be significantly more appropriate. And if the problem is too low potential growth, well then let’s find a way to increase it

Overheat to Raise Potential Growth?

March 19, 2014 4 comments

Update, March 20th: Speaking of ideological biases concerning inflation, Paul Krugman nails it, as usual.

On today’s Financial Times, Phillip Hildebrand gives yet another proof of unwarranted inflation terror. His argument is not new: In spite of the consensus on a weak recovery, the US economy may be close to its potential , so that further monetary stimulus would eventually be inflationary.

He then deflects (?) the objection that decreasing unemployment reflects decreasing labour force participation rather than new employment, by suggesting that it is hard to know how many of the 13 millions jobs missing are structural, i.e.not linked to the crisis. I think it is worth quoting him, because otherwise it would be hard to believe:

However, an increasingly vocal group of observers, including within the Fed, posits that more of the fall in the participation rate appears to have been structural than cyclical, and it was even predictable – the result of factors such as an ageing workforce and the effect of technology on jobs.

(the emphasis is mine). Now look at this figure, quickly produced from FRED data: Read more

Mario Draghi is a Lonely Man

January 10, 2014 7 comments

I just read an interesting piece by Nicolò Cavalli on the ECB and deflationary risks in the eurozone. The piece is in Italian, but here is a quick summary:

  • Persisting high unemployment, coupled with inflation well below the 2% target, put deflation at the top of the list of ECB priorities.
  • Mario Draghi was adamant that monetary policy will remain loose for the foreseeable horizon.
  • As we are in a liquidity trap, the effect of quantitative easing on economic activity has been limited (in the US, UK and EMU alike).
  • Then Nicolò quotes studies on quantitative easing in the UK, and notices that, like the Bank of England, the ECB faces additional difficulties, linked to the distributive effects of accommodating monetary policy:
    • Liquidity injections inflate asset prices, thus increasing financial wealth, and the value of large public companies.
    • Higher asset prices increase the opportunity costs of lending for financial institutions, that find it more convenient to invest on stock markets. This perpetuates the credit crunch.
    • Finally, low economic activity and asset price inflation depress investment, productivity and wages, thus feeding the vicious circle of deflation.

Nicolò concludes that debt monetization seems to be the only way out for the ECB. I agree, but I don’t want to focus on this. Read more

Of Actions and Words in Frankfurt

November 12, 2013 Leave a comment

Last Thursday the ECB cut rates, somewhat unexpectedly. This shows that it takes the risk of deflation very seriously. Good news, I’d say. But unfortunately, press conferences follow ECB Council meetings. And I say unfortunately, because Mr Draghi words often fail to match his actions. Here is what he said on Thursday (I could not resist adding some bold here and there):

If you look at the euro area from a distance, you see that the fundamentals in this area are probably the strongest in the world. This is the area that has the lowest budget deficit in the world. Our aggregate public deficit is actually a small surplus. We have a small primary surplus of 0.7%, compared with, I think, a deficit of 6 or 7% deficit in US, – 6 I think – and 8 % in Japan. This is the area with the highest current account surplus. And it is also the area, as we said before, with one of the lowest – if not the lowest – inflation rate.

Fascinating. Truly fascinating. I will pass on the fact that one of the strong “fundamentals” Mr Draghi quotes, low inflation, is actually the main source of worry for economists and policymakers worldwide, including the ECB, that had to rush into a rate cut that was not planned at least until December! I will also pass on his praise of high current account surpluses while the Commission itself is considering opening an infraction procedure against Germany, for perpetuating an important source of imbalances within the eurozone and worldwide.

No, what I find more shocking is the list of fundamentals Draghi gives: public debt and deficit; inflation; current account balance. Now, it dates back a little, but I remember all of those, in Econ 101, to be defined as instruments of economic policy, supposed to serve the final objectives of growth and employment. It is true that we do rather well in what Draghi calls fundamentals, but I continue preferring to call instruments. Look at this table:

I have reported, for ease of comparison, data from the IMF World Economic Outlook (October 2013), therefore they are not the latest (quarterly or monthly) data. Also, I have highlighted in red the worst performer, and in green the best. And boy, Draghi is right! (Notice incidentally that eurozone inflation was 2.5 percent on average in 2012. With the latest data at 0.7 percent, this suggests that  we are running, not walking, towards deflation.)

But if we look at the supposed objectives of economic policy (how would Draghi call these?), the picture changes, quite a bit:


No other major advanced economy is doing nearly as badly as the eurozone in terms of unemployment and GDP. But according to the ECB President we have “the strongest fundamentals in the world”. Does this means that Draghi did not take Econ 101? No, I know for sure that he did take it, and  he actually had excellent mentors. To understand Draghi’s claim, it may be useful to read his whole sentence. After arguing that the eurozone has strong fundamentals he goes on:

This does not translate automatically into a galloping recovery. But, actually, it gives you the fundamentals upon which you can pursue the right economic policies. Structural reforms are the necessary and sufficient condition for this to happen. In the absence of that, unfortunately, we are going to stay here for quite a long time.

Here is the answer. The only and one answer. Focusing on instruments instead of targets is the strategy of those who do not believe that a role exists for active economic policies. It is a pity that one of these guys is heading the second most important central bank of the world. And it is paradoxically reassuring that the situation is currently so bad that he is forced to abandon his creed and implement active monetary policies.

Advice for the next episodes: praise Mario Draghi actions, and avoid reading the transcripts of his press conferences.

Cockroach Ideas and Weak Arguments

April 10, 2013 1 comment

Helene Mees in a Project Syndicate Comment weighs into the dispute between Paul Krugman and the Commission officials, siding with Rehn and his people.
Mees’ criticism of Krugman is two-sided. First, she argues, Krugman omits to say that the OMTs program is subject to heavy conditionality, and that the signature of the fiscal compact was a necessary precondition for the adoption of the program. I don’t get it. The ECB is very vocal on austerity and on structural reforms, and it is clear that the OMTs program was adopted only at the very last minute, facing the perspective of eurozone collapse. A number of economists, including myself, welcomed the OMTs while criticizing the heavy conditionality attached to it. The very fact that the OMTs was reluctantly adopted shows that even austerity partisans cannot deny the fact that the EMU is desperately lacking a proper lender of last resort, of which the OMT is a pale surrogate. The more non-Keynesian institutions are forced to adopt Keynesian solutions, the more Krugman’s point is vindicated. I fail to see how the opposite could be true. Read more

Fear and Confusion in Frankfurt

April 4, 2013 3 comments

I must say I am puzzled by today’s decision of the ECB to leave rates unchanged. It simply does not fit with what Mario Draghi said during the press conference. Let me quote him.

Inflation expectations for the euro area continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. At the same time, weak economic activity has extended into the early part of the year and a gradual recovery is projected for the second half of this year, subject to downside risks. Against this overall background our monetary policy stance will remain accommodative for as long as needed.

If words actually mean what they mean, Draghi informed us that (a) inflation, and inflation expectations, are in line with forecasts and objectives; (b) at the same time, economic activity is weaker than expected, and the future recovery is at risk; (c) the ECB is willing to have an accommodative monetary stance.
Two considerations: first, the king is naked; it was obvious from the very beginning that the recovery in the second half of the year was not in the cards. I already discussed the systematic bias in official forecasts. It turns out that simply saying to markets that things will go well, is not sufficient to make them act accordingly. The confidence fairy, as Krugman calls it, is nowhere to be seen. I would add that this systematic bias risks making EMU institutions less credible, and hence further weaken their capacity to anchor private sectors’ expectations…
And then the puzzle: if inflation is under control, and if economic activity is weak, and if the ECB deems accommodation to be needed, why, why on earth are rates kept constant? Should we remind to Mario Draghi what is written in article 127 of the Lisbon Treaty?

The primary objective of the European System of Central Banks, hereinafter referred to as “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 Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union.

Among the general policies that the ECB should support there is growth and employment. And lowering the rates today would certainly not lead to “prejudice to the objective of price stability”

Why is the ECB so frightened to send the signal to markets that it is ready to boost economic activity? Is there an hidden agenda we are unaware of?

Leaks in the Dam?

March 28, 2013 1 comment

Interesting things happened this morning. I assisted to one of the presentations of the OECD interim assessment. There is nothing very new in the assessment, that concerning the eurozone, can be summarized as follows

  • The outlook remains negative (while the rest of the OECD countries are doing better)
  • There is still room for monetary accommodation
  • This monetary accommodation may not benefit the countries that need it more, because the transmission mechanism of monetary policy is still not fully working
  • The Cyprus incident shows that there is a desperate (this I added) need of a fully fledged banking union
  • EMU countries need to continue on the path of fiscal stabilization, even if automatic stabilizers should be allowed to fully play their role, even at the price of missing nominal targets Read more