The damage of monetary tightening is about to begin

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

The past weeks brought us four pieces of news on the inflation front. Well, actually, two pieces of news and two non-news. Let’s start with the latter. It is no longer news that central banks continue with their strategy of monetary tightening. Both the Fed and the ECB have raised rates by a quarter point, and the two presidents, Powell and Lagarde, are not revealing what will happen in September. What is certain is that, after the ninth consecutive hike, the rate for the eurozone is at its highest since 2001 when the ECB sought to support the value of the newborn single currency with high interest rates.

The second non-news is that inflation continues to decrease faster than expected. Data for France and Germany showed record lows since the invasion of Ukraine, while Spain’s inflation was slightly higher than expected. The tightening, therefore, continues while inflation falls. The official line of central banks is that this needs to happen because inflation has been “too high for too long,” and the risk is that it may become chronic, affecting expectations and wage negotiations.

No price-wage spiral

This argument is extremely weak, and, unfortunately i should add, there is no sign of wages chasing inflation. The OECD confirmed this only a couple of weeks ago in its 2023 Employment Outlook, which included a chapter on the generalized decline of real wages (a sign that nominal wages have grown less than prices).

Even expectations remain under control. After the two non-news items, the first news from last week is the results of the quarterly Survey of Professional Forecasters conducted by the ECB. According to the survey, professional forecasters expect inflation to return to 2% by 2024 (and to 3% in the last quarter of 2023). The ECB, on the other hand, continues to believe that reaching 2% will not happen before 2025. As a result, even among those who have supported the restrictive turn of the ECB in the past, voices calling for a pause in rate hikes are multiplying.

The decrease in inflation is mostly not due to the ECB

The hawks, on the other hand, base see the the decline in inflation as a justification of past rate hikes and as lending support for further increases in the autumn. The argument is that the tightening works and must continue until inflation returns to the 2% target. Unfortunately, this argument is flawed. The empirical literature has extensively studied the impact of central bank decisions on the economy. This mainly happens through the credit channel: the increase in central bank interest rates is transmitted to bank interest rates charged to businesses and households for investment projects and mortgages. The higher cost of capital implies less spending and and the cooling of the economy. This process is not immediate. While it is true that bank rates react fairly quickly to central bank decisions (especially to rate increases), spending is much stickier. For example, investment is a process that takes time, often years. It is unlikely that businesses will abandon an ongoing project just because the cost of money has increased. Therefore, the rate hike is transmitted with a certain delay, only as businesses complete ongoing investment projects and decide whether to start new ones. The same can be said for the other channel, that of exchange rates. The increase in interest rates causes an appreciation of the exchange rate and thereby a deterioration in trade balances, which cools the economy. Again, this process is not immediate because there are contracts to honor, spending habits to change, and so on.

For all these reasons, the transmission lags of monetary policy are measured in semesters, if not in years. The literature is abundant. A meta-analysis published a few years back tries to summarize these findings and reports that, on average, it takes 12-18 months to see the effects of a rate change on the real economy, and for the transmission to be complete, it takes about two and a half years. The delays are particularly long for countries with more developed financial systems, because there it is more difficult for the central bank to influence credit creation by the banking sector. This means that the impact of the credit tightening started in the spring-summer of 2022 is beginning to be felt now, and central banks have little to do with the decrease in inflation.

This brings us to the last news of the week, also from a survey. The results of the latest (July) quarterly Bank Lending Survey conducted by the ECB show (for the second consecutive quarter) a sharp decline in corporate credit demand (firms, anticipating an economic slowdown, are unwilling to borrow at increasingly prohibitive rates). Even for households and consumers there is a contraction in credit.

In short, while inflation has a life of its own, influenced only marginally by central bank decisions, these decisions are pushing us into an economic slowdown, which is showing multiple signals. In Germany, the Ifo business confidence index is at its lowest since last autumn, and the economy is stagnating after two quarters of slight contraction. Things are not much better in Italy, even though a recession is not currently forecasted in spite of negative growth in 2023 Q2. The “Congiuntura Flash” report published by Confindustria on July 29 shows a slowdown in the Italian economy mainly due to the weakness in industrial production and investment, with uncertain consumption and declining exports. Only the services sector (especially tourism) is keeping the Italian economy afloat.

We need to stop relying solely on central banks.

What does this picture tell us, besides the obvious fact that central banks persist in a futile and harmful strategy? First, in the coming months, measures will need to be implemented to mitigate the impact of monetary tightening, which will begin to fully unfold and, as usual, hit the most vulnerable categories. Second, the era of delegating the solution to all our problems solely to monetary policy must end. Since at least 2010, when the sovereign debt crisis began, monetary policy has been the only player in town, for better or for worse. It’s time to rethink the policy mix, the attribution of different economic policy tools and objectives to various actors. But this subject will need to be tackled in a future post.

Could Central Banks do More during the Crisis?

I rarely disagree with Martin Sandbu’s Free Lunch. But today’s piece on central banks is one of these cases.

In short, Martin argues that while the main culprit for the slow recovery is fiscal policy, almost everywhere too timid if not outright procyclical (we are all on board on that!), the mistakes of fiscal authorities do not exempt central banks from bearing part of the responsibility. In particular, he dismisses the claim that it was technically impossible to lower long-term interest rates further, and/or bring policy rates even more into negative territory.

I agree with this point. Interest rates could have been lowered further. Nevertheless, I think that this would have made very little difference, because after 2008 central banks were essentially pushing on a string.  This point of disagreement between us can be traced to a different view about what is the liquidity trap.

I recently published a book, La Scienza inutile (a general public account of a century of debates in macroeconomics. For the moment it is in Italian and in French, English translation in progress), in which I discuss the different notions of liquidity trap. Here is the quote (sorry, a bit too long):

 The first source of trouble that Keynes considers is the most extreme, the so-called liquidity trap: `There is the possibility, […] that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest’ (Keynes 1936, p.207). In slightly more technical terms, the interest elasticity of money demand is near-infinite: no matter how much liquidity the central bank injects into the economy, it is entirely hoarded by agents and hence it leaks out of the system in its entirety. Monetary expansion is not effective in lowering interest rates.

There may be different reasons why the economy enters a liquidity trap. Keynes argued, by looking at the great depression, that this usually happens at very low (but not necessarily nil) levels of the interest rate, because in this case agents would expect interest rates to rise in the future and thus would be willing to hold any extra amount of money and postpone the purchase of bonds to the moment when interest rates will be up again. More recently the liquidity trap has been defined as a situation in which the interest rate that equates savings and investment is negative, and therefore cannot be attained by the central bank (the so-called Zero Lower Bound, or ZLB; see e.g. Krugman 2000). This latter definition leaves some room for monetary policy effectiveness: if the central bank manages to trigger the expectation of positive inflation, the real interest rate (the nominal interest rate minus the inflation rate) will become negative and lead to the full employment equilibrium.

So, if we think in terms of ZLB, it exists a real interest rate at which the output gap would be closed. If that interest rate is negative, then it is harder to reach, as central banks need to raise inflation expectations and try to push short term rates as much as possible in negative territory, which requires boldness and creativity (we have seen this). But, once again I agree with Martin on that, this can be done. If instead private expenditure becomes irresponsive to interest rates, the ‘Keynes definition’, then there is little central banks could do. I had noticed, back in 2016, that while it succeeded in easing credit conditions, EMU Quantitative Easing seemed to have done little to boost confidence and expected demand (the ultimate driver of firm’s credit needs). The EMU most recent Bank Lending Survey seems to confirm the prediction of the time. Both chart 4 (enterprises) and chart 12 (households) depict a flat demand for loans, that picks up only when the EMU economic outlook brightens.

This is by no means hard evidence (I am not aware of any papers thoroughly investigating the impact of QE on credit demand). But stylized facts seem to acquit central bankers.

 

 

ps

The two works cited in the quote:

Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: McMillan.

Krugman, P. (2000). Thinking About the Liquidity Trap. Journal of the Japanese and International Economies 14(4), 221–237.

Walls Come Tumbling Down

Yesterday I quickly commented the disappointing growth data for Germany and for the EMU as a whole, whose GDP Eurostat splendidly defines “stable”. This is bad, because the recovery is not one, and because we are increasingly dependent on the rest of the world for that growth that we should be able to generate domestically.

Having said that, the real bad news did not come from Eurostat, but from the August 2014 issue of the ECB monthly bulletin, published on Wednesday. Thanks to Ambrose Evans-Pritchard I noticed the following chart ( page 53):

The interesting part of the chart is the blue dotted line, showing that the forecasters’ consensus on longer term inflation sees more than a ten points drop of the probability that inflation will stay at 2% or above. Ten points in just a year. And yet, just a few pages above we can read:

According to Eurostat’s flash estimate, euro area annual HICP inflation was 0.4% in July 2014, after 0.5% in June. This reflects primarily lower energy price inflation, while the annual rates of change of the other main components of the HICP remained broadly unchanged. On the basis of current information, annual HICP inflation is expected to remain at low levels over the coming months, before increasing gradually during 2015 and 2016. Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with the aim of maintaining inflation rates below, but close to, 2% (p. 42, emphasis added) 

The ECB is hiding its head in the sand, but expectations, the last bastion against deflation, are obviously not firmly anchored. This can only mean that private expenditure will keep tumbling down in the next quarters. It would be foolish to hope otherwise.

So we are left with good old macroeconomic policy. I did not change my mind since my latest piece on the ECB. Even if the ECB inertia is appalling, even if their stubbornness in claiming that everything is fine (see above) is more than annoying, even if announcing mild QE measures in 2015 at  the earliest is borderline criminal, it remains that I have no big faith in the capacity of monetary policy to trigger decent growth.  The latest issue of the ECB bulletin also reports the results of the latest Eurozone Bank Lending Survey. They show a slow easing of credit conditions, that proceed in parallel with a pickup of credit demand from firms and households. While for some countries credit constraints may play a role in keeping private expenditure down (for example, in Italy), the overall picture for the EMU is of demand and supply proceeding in parallel. Lifting constraints to lending, in this situation, does not seem likely to boost credit and spending. It’s the liquidity trap, stupid!

The solution seems to be one, and only one: expansionary fiscal policy, meaning strong increase in government expenditure (above all for investment) in countries that can afford it (Germany, to begin with); and delayed consolidation for countries with struggling public finances. Monetary policy should accompany this fiscal boost with the commitment to maintain an expansionary stance until inflation has overshot the 2% target.

For the moment this remains a mid-summer dream…

 

ECB: Great Expectations

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…

End of The Tunnel?

There are signs of optimism around. Cautiously, policy makers and commentators start discussing the shape (and the fragility) of the future recovery.  Martin Wolf on the Financial Times already speculates on the timing of reversal to a normal state of affairs. Wolf is rightly worried by the temptation to reverse policies too fast, a mistake we made already at the end of 2009, when stimulus plans were reversed into consolidation far too soon.

As a rule of thumb, I’d argue that exceptional involvement of governments in the economy should stop when the private sector is ready to take the witness. Stimulus plans and monetary easing should be rolled back once private spending resumes (or is ready to resume), and when the credit market is sufficiently loose. So the question is, how does private sector behaviour fit, within this moderate optimistic mood? Not too well I am afraid…