Has the ECB run out of monetary road?

Survey data has pointed to weaker global activity for some time now, notably in manufacturing, but the hard data surprised to the upside in the first quarter, with world growth an anualised 3.3% from 2.75% in the final quarter of 2018. Markets are  increasingly nervous , however, fearing that the deterioration in US/China relations will have a much more serious impact on global trade than seen to date. The flight from risk has seen chunky falls in equity and commodity markets while the 10-year German bond yield is trading at -20bp, with the corresponding yield on US Treasuries falling from 3% to 2.10%.

Part of that latter decline can be attributed to a substantial change in  expectations about monetary policy, with the futures market currently priced for a Fed Funds rate of 1.85% by year-end, from the current 2.40%. US growth appears to have slowed in the second quarter (the Atlanta Fed model is tracking an annualised 1.2%  from over 3% in q1)) but to date there is little to suggest that the States is slowing sharply enough to warrant that kind of easing. That could change, of course,  and some at the Fed are already concerned about inflation being a little low particularly given the strength of the labour market.The FOMC also appears to be giving more weight to global factors in its policy deliberations, despite the fact that the US is a relatively closed economy in terms of external trade, and to financial conditions, notably the stock market.

The Fed had already announced that it will stop reducing the size of its balance sheet and  clearly has some room  to cut short term rates, which contrasts with the ECB, as the latter has not been able to tighten policy despite a prolonged recovery in economic activity in the Euro area, and  facing into a possible downturn with  a zero refinancing rate and a negative deposit rate.

The Governing Council in Frankfurt was confident last year that the tightening labour market would push up wage inflation and ultimately price inflation but has been forced to consistenly revise down  forecasts of core inflation. Consequently, the first suggestion of  monetary tightening, based on forward guidance signalling a likely  rate rise around September this year, was  then modified to the end of 2019 but that too looks redundant given that market rates now  only imply a 10bp rate rise from current levels in early 2022. Indeed market rates are now priced to go modestly lower still over the next year.

The failure of the ECB’s various policy tools to generate underlying inflation anywhere near  target prompts the obvious question as to what the Governing Council can do now, particularly if growth slows sharply. Another round of cheap long term loans to banks is likely and forward guidance will no doubt be extended but banks are awash with liquidity as it stands, while the negative deposit rate is hurting bank profits, a fact acknowledged of late by the ECB, as well as sending a signal to the population at large that we are still in an economic crisis, despite tha fact that unemployment across the zone has just fallen to levels last seen in 2008. Another round of asset purchases is also a possibility, although that may face tricky issues around the Capital key and the Bank’s already high ownership share of some  government bond markets.

The  broader debate about whether monetary policy can be effective at or near the lower bound in rates, alongside scepticism about the impact of QE on consumer prices (as opposed to asset prices) has prompted renewed interest in fiscal policy , having fallen out of favour in mainstram economic thinking over recent decades.

Some economists now argue that the low rate environment changes the cost/ benefit equation in favour of expansionary fiscal policy. The case is that in many countries the average interest rate on the debt is now below the growth rate of GDP, so on standard debt dynamics a government could run a primary deficit and still put downward pressure on the debt ratio, A more radical strand, based on Modern Monetary Theory, argues that for any country with full monetary sovereignty ( i.e. it can print its own money)  a debt default can only occur as a policy choice and that there is no great reason why such countries should not run budger deficits to boost employment or to achieve  other socially useful goals, paid for by printing the money rather than through higher taxes or issuing bonds.

The latter approach has many mainstream critics but is not applicable anyway in  the euro zone ( no member state can print euros)  while the ECB will no doubt argue it has not run out of policy options. One  radical approach discussed in academic circles is for Central Banks to adopt a more flexible inflation target or even a range and Draghi himself has stated that the ECB’s inflation target is not a short term ceiling, implying a tolerance for above target inflation for a while. This emphasis on expectations in determining inflation perhaps puts too much weight on that component and low inflation may owe far more to structural factors such a globalisation, free trade (to date at least ) and a much lower  equilibrium real rate of interest, so rendering a 2% inflation target as unachievable anyway, let alone a higher inflation rate.

In fact fiscal policy in the euro area is already set to be a litle more expansionary this year anyway, but in the event of an outright recession we are likely to see much more aggresive fiscal expansion across the zone, albeit without a public acknowledgement that policy makers in the EA erred in recent years in making monetary policy, and hence the ECB, the only player in town.

Draghi as Sisyphus

Inflation in the euro zone has been below 2% for three and a half years now  and under 1% for almost two years, with the latest figure for August at 0.2%. Many people would think this a good thing in a period of very modest wage growth, as it supports real incomes, but it is a failure for the ECB , as its goal is price stability, which it defines as inflation  close to but below 2%. Very low inflation risks deflation in the Bank’s view and although the inflation trend is heavily influenced by weak commodity prices core measures are also weak: excluding food and energy,  inflation was 0.8% in August, indicating very little price pressures.

The ECB was slower than other Central Banks in cutting interest rates but the main refinancing rate is now at zero alongside a negative deposit rate of -0.4%, all designed to encourage banks to lend into the real economy. That approach reflects the importance of banks in the EA as the main providers of credit and the ECB has recently gone further down that particular road, with its  latest TLTRO scheme, allowing participating banks  to access  four-year funds at an interest rate which could fall to the -0.4% deposit rate depending  on lending growth. In other words the ECB could end up effectively paying some banks to lend money.

The ECB also decided to by-pass the banking route by embracing QE, with the purchase of government and corporate bonds designed to push down longer term rates. To date , some €1,165bn assets have been purchased, including over €940bn in government bonds, with the programme currently projected to run until March 2017.

Has any of this worked? Growth in the EA is averaging  around 0.4% per quarter, hardly stellar, but sufficient to put downward pressure on the unemployment rate, which has fallen to 10.1% from a peak over 12%. Bank credit has also started to rise, from a very weak base, with  lending to the private sector growing at an annual 1.7% rate in July and the ECB has been keen to point out that the cost of funds for EA banks in general has fallen steadily as a result of monetary policy decisions.

Yet credit growth is still contracting in many countries, including Ireland, despite ample liquidity. Indeed, data from the Central Bank here shows that in July deposits in Irish banks exceeded loans, a far cry from the 190% loan to deposit ratio seen pre-crisis. This highlights that in some countries deleveraging is still a dominant force and there are other factors at work, including capital issues for some banks, the scale of non-performing loans and the appetite from lending institutions to take on risk.

Negative rates are also an issue, in that they are putting downward pressure on net interest margins; banks are reluctant to cut deposit rates below zero but many of their loans are linked to market rates, which are falling. Initially the ECB was loathe to accept this point, arguing that higher loan growth would be an offset, but in the  minutes of the last Council meeting there was concern expressed  about the profitability of EA banks and their low stock market valuations, increasing the cost of capital for banks and hence reducing lending.

These concerns may dissuade the ECB from further cuts in the deposit rate and they also face problems with QE, in that the universe of government bonds available for purchase is shrinking, and in some cases the 33% issuer limit is likely to become a binding constraint- that will be the case in Ireland, for example. The ECB could change that limit or extend its purchase of corporate debt, although the latter already moves the Bank into allocating credit directly, which may make some Council members uncomfortable as well as stretching its mandate..

The bigger question is whether all this is having any impact on inflation and the answer would appear to be in the negative. Rather than increasing the bet, the ECB might reconsider its whole approach, with a growing  number of policymakers across the globe examining the case for more expansionary fiscal policy. On that point it was notable that the Fiscal theory of the Price Level got an airing at the recent Jackson Hole gathering, with a paper delivered by Princeton’s Christopher Sims, who is closely associate with that approach. The theory is that the price level is influenced by fiscal policy as  well as monetary policy, and argues that low interest rates  can be deflationary , in that they reduce debt service for governments and unless offset by higher spending or tax reductions will result in contractionary fiscal policy.

Generating inflation in the current environment requires much more expansionary fiscal policy, it is argued, and we may indeed end up with a changed fiscal approach in some countries, including the UK, albeit for different reasons. That appears very unlikely in the EA however, and President Draghi may end up like the legendary Greek king, doomed to push a boulder up the hill only to see it always roll back.