What next for the ECB?

The ECB faces some tricky policy decisions  and judging by the minutes of the last meeting the Governing Council has no clear view on how to proceed. The euro zone economy has surprised to the upside this year, bank credit across the zone is  growing again, the redenomination risk in sovereign bond markets has long gone and the unemployment rate has fallen to 9.1% from  a peak of over 12% , all of which  might  argue for a change to policies born in a crisis environment or adopted when deflation was perceived as a real danger.

Yet the ECB”s (self-imposed) goal remains elusive- inflation is not ‘close to but below 2%’ and according to the current staff forecast that will remain the case for some time, with an average of 1.5% projected for 2019. Indeed, according to the minutes, some council members questioned whether the staff had used an appropriate pass-through rate from the euro’s recent appreciation and hence wondered if the inflation forecast was actually too high.

The minutes also revealed ‘discomfort widely expressed’ about the length of time inflation had been and was expected to remain below target, and that ‘a very substantial degree of monetary policy accommodation was still needed for inflation to converge sustainably to levels in line with the Governing Council’s aim’, which would imply that we are unlikely to see a substantial policy shift in the near trem. Indeed, ‘any reassessment of the monetary policy stance should proceed in a very gradual and cautious manner‘.

So what are the options?. Policy as it stands includes the purchase of €60bn assets a month until the end of December this year ‘or beyond, if necessary‘. The minutes would indicate an abrupt halt in  a few months is out of the question but there are logistical issues in a number of countries, given  the current 33% issuer limit on sovereign bonds. Consequently, the market is anticipating some form of ‘tapering’, and the minutes discussed the merits of continuing to buy for  a longer period but at a slower monthly pace against a higher monthly volume over a shorter time frame.

The former is perhaps more likely, as it better ties in with another strand of policy, a commitment to keep interest rates at current levels  for an extended period and ‘well past the horizon of the net asset purchases’. This explicit linking of forward guidance on rates to QE argues for extending the latter for a longer period if the ECB wants to influence rate expectations and that might indeed have an additional impact, this time on the exchange rate. We know the Bank is concerned about the currency’s appreciation, and if one rules out explicitly talking it down one lever left is to convince markets that rates will stay lower for longer.

The ECB will also no doubt emphasise that it intends to keep reinvesting the proceeds of maturing assets but the net asset decision will be key, and lower for longer may well be the mantra that decides the latter.

 

Are Inflation targets too high?

Inflation targeting by policy makers emerged in the early 1990’s and is now part of the standard toolkit for most central banks, with operational independence from government also the norm. The idea is straightforward; if the central bank commits to hitting a specific inflation rate, that rate will impact expectations and eventually will help to anchor price changes. Too high a figure means that purchasing power is eroded at an unacceptably fast pace, while too low risks periods of deflation.

The latter view persuaded central banks to eschew a zero inflation target, and the figure of 2% is very common, although of course it means that prices rise by 22% over a decade and by 50% in a generation.  Hardly stable prices then, although one should remember that such targets  were often set some time ago and at a period when inflation was generally above that figure.In contrast, many central banks have been wrestling with the opposite problem for some time i.e. inflation is persistently below target.

In the US, for example, core inflation ( the CPI excluding food and energy) has been below 2% for almost a decade, while in the euro area the last time core inflation exceeded 2% was back in 2003. This points to structural factors at play, rather than purely cyclical drivers.

Standard inflation models , however, generally posit a cyclical  link between economic activity and inflation, with periods of stronger growth resulting in an acceleration in inflation. The link is often based on the Phillips curve, the idea that falling unemployment will boost wage growth and hence lead to price rises. Consequently, most central banks expected inflation to pick up given falling unemployment, particularly as rates for the latter are now very low by historical standards in some countries, including the US and the UK. Yet wages have not picked up as expected ( the Phillips curve has flattened), reflected a range of factors, many of them structural, including globalisation and free trade, a shift in employment composition to lower productivity jobs, the rise in self employment,  fear of job losses and the decline in trade unions .

There may be other factors directly impacting inflation, such as the greater ease of price discovery in a digital age and the growth of disruptive technology, ( examples might be Amazon and Uber) which are replacing traditional models of distribution. Technology change is general is also shifting the aggregate supply curve rightward, so putting downward pressure on prices.

Yet the Fed and the ECB are still wedded to a 2% inflation target, despite missing it to the downside for a long period. Fed chair Yellen did acknowledge recently  that inflation was not behaving as expected ( calling the recent inflation performance ‘a mystery’) but the FOMC and the ECB are both of the view that cyclical factors will eventually win out, pulling inflation up to target.They may be ultimately proven right, although the recovery is now pretty long in the tooth, particularly in the US, and the Fed has revised down its view of long run potential growth ( now sub 2%) although not of long run inflation, still at 2%.

Does it matter if inflation was to stay in a 1%-1.5% range. It’s obviously better than 2%  for many people in an era of weak wage growth but it does raise a policy issue- if ‘equilibrium inflation’ is now below 2% due to structural changes, then policy will be too loose if it is set to hit 2%. The liquidity currently flooding the world has indeed driven up prices, but equities and property rather than the price of goods and services.

 

ECB caught between strong growth and weak inflation

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A  ‘reflation’ reference by Draghi was the initial  catalyst ( although later played down by the ECB)  and the pace of economic activity has  certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area  (EA) grew by 0.6% in the first quarter and  strong  survey readings  (the IFO in Germany is currently at  a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the  EA may emerge at 2.1% or 2.2% this year and hence above the 1.9%  projected in the June  ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA  but across  other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e.  a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision  in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand  ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer  limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a  gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed  also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening,  but the ECB does not have that luxury.

European Commission latest to convert to Fiscal Expansionism

The widely accepted view on the Great Depression is that it was exacerbated by a series of policy errors- trade protectionism, tight monetary policy and contractionary fiscal policy. Consequently, given the lessons learned,  the Great Recession in 2008-9 prompted a substantial policy reaction across the globe, with a massive easing in monetary policy accompanied by counter cyclical fiscal policy. Oddly, though, policy makers then decided that debt reduction should take priority, and fiscal policy generally became contractionary even when the global recovery began to falter and lose momentum, with monetary policy seen as ‘the only game in town’. That emphasis on the  perceived dangers of high and rising  sovereign debt resulted in new and stricter fiscal rules in the Euro Area (EA), emphasising the need for a steady and persistent reduction in budget deficits.

Policy doubts eventually began to emerge, including from the IMF, with evidence questioning whether ‘austerity’ actually reduced debt levels and claiming that the  negative multiplier effects of contractionary fiscal policy were steeper than previously believed. Doubts also grew about the effectiveness (and  possible adverse consequences ) of loose monetary policy particularly after the adoption of negative interest rates and large scale QE. The ECB has also changed its tone of late, accepting the need for monetary policy to be complemented by some expansionary fiscal policy in the EA, albeit while still respecting the existing fiscal rules.

Academic debates  on fiscal policy have also intensified, with the case being made that budgetary policy can be more effective at or around the zero rate lower bound, but  events have transpired to take fiscal policy centre stage in the real world. The UK government has already announced , post the Brexit vote, that it has abandoned its previous pledge to balance the budget by 2020, and is expected to announce a more expansionary fiscal path later this month. In the US,  markets now expect fiscal policy to be far more expansionary under the incoming Trump Administration, although it remains to be seen how much of the campaign rhetoric will translate into policy action.

Closer to home, the European Commission has just announced , for the first time, a recommendation on the overall fiscal stance in the EA, and is advocating that it should be expansionary in the coming year, amounting to 0.5% of GDP , equivalent to a €50bn budgetary injection. On existing  national plans , the  overall  EA fiscal stance is expected to be neutral in 2017, after being modestly expansionary in 2016, and the Commission believe that a number of countries have the fiscal space available to raise spending and/or cut taxation, although it cannot force any action. The group comprises Germany, Estonia. Malta, Latvia, Luxembourg and the Netherlands. In practice, the Federal Republic is the only member with the size to affect the EA as a whole, and while calls for Germany to adopt a more expansionist policy in the interests of the wider zone have been made before, it is novel and perhaps surprising to see Brussels join in that chorus.

Negative Deposit rate hitting profitability of euro banks.

The ECB first cut its deposit rate to negative territory in June 2014, to -0.1%, and reduced it again late that year, to -0.2%, with a third cut taking it to -0.3% in December 2015. A further reduction was announced last month, to -0.4%, and since then criticism of the move has intensified, most notably of late from the German Finance Minister, concerned at the low return for savers.  Low and negative bond yields are putting pressure on insurance companies with products offering a guaranteed return and  the ECB’s deposit rate is particularly irksome for  the hundreds of small savings banks across the Federal Republic, given that retail deposit rates cannot fall below zero.

That squeeze on margins is not an exclusive German phenomenon, of course, and any banking system with a high dependency on retail deposits will be affected. Ironically, perhaps, banks in general have been urged to reduce their dependence on  the wholesale markets , and new Basel III rules on liquidity and funding also push banks towards deposits.

The ECB has recently responded to the criticism  by arguing that any squeeze on net interest margin  can be more than offset by higher loan growth, which the policy is designed to stimulate, and the capital gains resulting from the fall in bond yields. In that context the results of the latest  ECB Bank Lending Survey (BLS) for April is instructive, as it includes a number of ad hoc questions regarding the impact of non-standard monetary policy, including the effect of  the  negative  deposit rate. Not one  bank felt the deposit rate had a positive impact on their net interest income, with 63% stating a negative impact and another 18% a very negative effect, giving a net negative figure of 81%. Asked about the next six months, the net negative figure climbed to 85%. The vast majority of banks had seen no impact on loan volumes, although there was a small net positive, but this was offset by the negative impact on margins, so reducing overall income.

The survey also asked respondents about the impact of the ECB’s asset purchase programme, and again the results are unlikely to raise too much cheer in Frankfurt. A  small net number of banks (4%) had sold sovereign bonds as a result of QE and those experiencing capital gains in general  on assets for sales was a net positive 12% but that benefit was also more than offset by the net interest margin impact, with a net 27% seeing a fall in NIM. The result was that only 9% of banks had seen profitability rise as a result of QE, with 28% experiencing a profit fall, leaving a net decline percentage of 19%.

On the positive side QE was seen to have  improved the liquidity position of banks and  access to financing, notably via covered bonds, and the ECB has of late highlighted these metrics as a sign that  non-standard measures are working. Credit to the private sector is also finally growing again, albeit by an annual 0.9% , but for the moment at least the evidence supports the view that negative rates, in particular, are having a detrimental  effect on bank profits. It remains to be seen how that will change when the ECB’s long term loan scheme comes on stream.

 

 

 

The ECB’s Scattergun

The provision of credit in the Euro Area (EA) is largely delivered through the banking system, in contrast to the US, where capital markets are the main source of  loans. That explains, to some degree, why the ECB sought to flood the banking sector with liquidity following the financial crash in 2008, as opposed to seeking to influence the real economy more directly via the purchase of assets (QE). The Bank has  subsequently travelled a long way in its quest to boost economic activity  and is now utilizing a plethora of instruments in an attempt to hit its inflation target , although this scattergun approach may yield further disappointment.

In June 2014 the ECB was still of a mind that bank funding costs were the problem and announced a Targeted Long Term Refinancing Operation (TLTRO). Banks could borrow up to 7% of their existing loan book (defined as  lending to the non-financial private sector excluding mortgages) in two tranches, in September and December, at a cost equal to the refinancing rate (at that time 0.15%) plus 10 basis points. Banks could borrow more in subsequent quarterly tranches if their lending grew above stated benchmarks, with all lending to be repaid by September 2018.. In the event the take-up was disappointing, amounting to €212bn in the first two tranches , rising to a cumulative €418bn by end-2015, with the take-up in December just €18bn. This compares with total outstanding loans to the private sector of €10,600bn. The funding could not be used for mortgage lending and banks were no doubt influenced by the fact that loans had to be repaid early (by June 2016) if the benchmarks were not being met.

The ECB effectively accepted that the first TLTRO was not a success by announcing TLTRO II last week,allowing banks to repay early existing loans under the first scheme to encourage a switch into the new variant. This one  is designed to boost ‘lending’ as opposed to ‘lending to the real economy’ and there does not appear to be any restrictions. The scheme will start in June, with four quarterly tranches up to March 2017, and loans mature in four years from the time of origination, Banks this time can borrow up to 30% of their non-mortgage loan book at the refinancing rate , which is currently zero. Moreover, banks that are growing their loan book can borrow at a lower rate, down to the deposit rate, which is currently -0.4%. The pool of existing loans amounts to €5,600bn so in theory the amount of TLTRO borrowing could be substantial, with a 60% take-up implying a figure of €1,000bn.

So the ECB has sought to offset the impact of a negative deposit rate on the profitability of the banking system by allowing banks to borrow at that rate, or at least some of them. But is weak lending a function of funding costs?. The answer is probably no, at least for many banks; market rates have tumbled, allowing banks to borrow at very low rates anyway, without tying up collateral for years at the ECB, with capital , profitability and risk aversion the key issues on the supply side of the credit market. Others would argue that the demand for credit is weak anyway, given the uncertain economic outlook, and that the ECB’s decision to cut the deposit rate deeper into negative territory reinforces that uncertainty rather than assuaging it. Deleveraging is also a factor, particularly in Ireland, with many households and firms preferring to repay rather than add to debt.

The ECB has also partially undermined the rationale for the TLTRO by announcing the decision to extend its asset purchase scheme to corporate bonds . This will presumably encourage firms to issue debt and so disintermediate the banking system. Purchases will only include investment grade debt. which also implies that many corporates in the periphery of the euro zone will be excluded, with bank borrowing their only option. So bank lending to low risk corporates may fall, raising the risk profile of any remaining bank lending.

The ECB may also have hoped that’s this suite of measures would help to push the euro down, but that has not transpired, at least for the moment, partly due to  Mario Draghi’s comment that  ‘we don’t anticipate that it will be necessary to reduce rates further’. In that context it is interesting that Peter Praet, a member of the Executive Board, has subsequently sought to emphasize that we are not yet at the lower bound on rates, an indication that the Bank was not happy that the euro appreciated post- conference.

 

Negative rates are a mistake

The next ECB policy meeting is scheduled for March 10th, and the market is expecting further monetary easing. This was flagged in January , when it was announced that the Governing Council would ‘review and possibly reconsider the policy stance‘  given that downside risks had risen. The minutes  show that some Council members favoured  immediate action but the consensus was to await the publication of the quarterly macroeconomic forecasts, incorporating projections out to 2018. The current forecasts envisage inflation rising from 1.0% this year to 1.6% next, but are predicated on an oil price of $52 a barrel in 2016, which looks untenable in the absence of a seismic shift in global oil supply. Headline inflation had turned positive again in late 2015 and rose to 0.3% in January but the flash reading for February was surprisingly weak, at -0.2%, with  core inflation also slowing to 0.7%.

Euro bond yields have fallen and the euro has depreciated of late in anticipation of ECB action, but the Bank has been cautious in terms of inflating expectations, mindful of the market reaction to its December announcements, which were deemed disappointing relative to what Mario Draghi was interpreted as signaling. The euro’s effective exchange rate subsequently appreciated , rising by 6% to mid-February, and speculative short positions in the euro/ dollar fell sharply. Of course there were other factors at work, including changing expectations about US monetary policy, but it is noteworthy that the ECB minutes warned against raising ‘undue or excessive expectations about policy action’ given what had happened in December.

What can the ECB do?. One option is to reduce the Deposit rate further into negative territory, as other central banks have done, The rate, currently -0.3%, is paid on overnight deposits at the ECB and  the idea is that  banks will be encouraged to lend to other banks or to use these reserves to support lending to the private sector, rather than face losses by continuing to park it with the ECB. A cut in the deposit rate, it is  also argued, will put further downward pressure on money market rates and bond yields, so precipitating a fall in the currency, which would in turn help to boost inflation.

Yet rates paid by banks to depositors are unlikely to turn negative and many loans are based on money market rates, such as 3 or 6- month euribor. Consequently negative rates hit bank margins and hence profitability. Some argue , including ECB Board Members, that this can be offset by strong lending growth but that is certainly not happening in the euro area, with the annual growth in loans to the private sector at just 0.6% in January . Consumers and firms in many countries are still reducing their debt levels (including Ireland, where net credit has been contracting now for 6 years) and on the supply side banks are building capital to meet changed regulatory requirements and are saddled with high  levels  of non-performing loans. Moreover, lending to consumers or businesses is risky and requires higher capital cover than lending to governments , where zero capital is required, particularly when the ECB is in the market buying government debt. The general public may feel that bank profitability is the least of their concerns but a healthier bank system is required if the euro area is to see stronger economic growth and negative rates will not help.

Moreover, negative rates send the signal that economic conditions are far from normal and may exacerbate the perception that monetary policy has indeed reached its limits, and may now be adding to problems rather than easing them. It is also not a given that a further rate cut by the ECB will lead to a sharp depreciation in the euro- witness the recent rally in the Yen following the bank of Japan’s move into negative rate territory- and the euro area’s huge current account surplus means capital outflows have to be enormous to push the currency lower on a sustained basis.

Conceptually, negative deposit rates, if expected to last a long time, could  also lead to a fundamental change in the financial system. Rates on cash are not negative ( excluding some storage costs ) so banks may decide to hold excess reserves in cash rather than deposit them with the central bank. Similarly, retail depositors would have an incentive to do the same thing if commercial banks sought to introduce negative deposit rates on a large scale, so threatening the main function of the banking system, the intermediation of savers and borrowers.

In sum, negative rates are not the answer and symptomatic of a refusal by central banks to accept that the emperor no longer has any clothes. Time  for Governments to take advantage of historically low or even negative bond yields and fund some sensible capital spending , which would boost demand in the short term and support higher growth further out.

 

Euro and Oil price likely to prompt ECB action

The Euro Area has experienced economic growth for eight consecutive quarters and the pace of expansion this year is likely to average around 1.6% from 0.9% last year.  Most forecasters, including the ECB, expect that pace of growth,  of around 0.4% a quarter, to continue into next year and alongside  rising oil prices is projected to lead to a pick up in inflation , to 1.1% in 2016 and 1.7% the following year, and as such nearer the  target level. Recent developments in the exchange rate and the oil price may prompt a forecast revision, however, and the ECB has just flagged that it may take further policy action in December, contingent upon an updated inflation forecast.

Headline inflation. which had been negative early in 2015, turned positive in the Spring but has weakened again of late, with September recording another negative number (-0.1%). Energy prices fell by 1.7% in the month and are down some 9% on an annual basis, which  of itself reduces the overall inflation rate by 1 percentage point. Core inflation is also weak, however; prices rose by just 0.9% if one excludes food and energy while inflation in  services, which accounts for over 40% of the index, is just 1.2%.

The current ECB forecast is predicated on a rise in oil prices to an average of $56 a barrel next year, but this now looks too high; the current forward price of Brent implies a figure around $52. Moreover, the ECB expects the euro to average $1.10 , and as such are clearly concerned about the currency’s recent performance, with a 7.5% appreciation against the dollar since the Spring, taking it above $1.13 from below $1.06, and a 6.5% rise in the trade weighted exchange rate. Consequently, the forecast price of oil in euro terms of €51 now looks wrong on two counts, and may be closer to €46 in the December forecast in the absence of a significant fall in the euro on the FX markets.

Engineering such a fall may be difficult in the absence of stronger US data and a tightening of monetary policy by the Fed but the ECB is likely to take some measures. President Draghi took a step in that  direction at today’s press conference by opening the possibility of a cut in the rate the ECB pays for overnight deposits from the banking system. The Deposit rate was cut to -0.2%  over a year ago and Draghi had indicated that it was at the effective lower bound but that may no longer be the case, judging by his latest remarks.

Apart from a Deposit rate cut the ECB has also indicated that it will use other instruments to ease policy further if deemed necessary. The simplest. and most likely, is an expansion of the current asset purchase scheme , which could take the form of a higher volume of monthly purchases , a broadening of the assets deemed eligible or a prolongation of the time frame of the programme.

It may well be that we are at the effective limits of monetary policy, and further QE may be both ineffective and political troublesome for the ECB, as it carries implications for income distribution. Some council members have talked about the need for non-policy measures and it may well be that the whole fiscal policy debate will be reopened but for now the ECB remains the only game in town.

Massive excess supply pushing oil prices down.

Energy , which accounts for almost 10% of the Irish CPI and  a slightly higher share of the equivalent EA index, tends to be the most volatile inflation component. This reflects the nature of crude oil  demand , which is very unresponsive to price in the short run and so small changes in supply can have a large impact , although the full  knock-on effect on the market price of fuel is diluted somewhat by the incidence of tax, which is high in many European countries, including Ireland. This works to dampen the effect of a sharp rise in crude prices and to reduce the gain to consumers following a large fall, although the impact on the CPI can still be significant if the move in crude prices is large enough.

That has certainly been the case in 2015; Irish energy prices in July were 6.7% lower than  the previous year with a similar  fall across the EA, helping to reduce overall inflation rates. For example, the annual  EA inflation rate in August was just 0.2% instead of 1.1% if one excludes the energy impact.

The consensus view, and one shared by the ECB, envisaged inflation picking up in the latter months of 2015 as the impact of weaker  energy prices dropped out of the annual inflation rate but that now looks less likely following renewed falls in energy and other commodity prices; the price of Brent crude had appeared to be stabilising  at over $60 a barrel in the early summer but started to slide in July, with the decline gaining momentum through most of August, to a low of under $43 at one point, levels last seen during the global financial crash in late 2008. Brent has recovered a little ground of late but that plunge, which was even sharper in euro terms, should translate in to another round of lower fuel prices and hence overall inflation rates- our  own Irish Petrol Price Indicator points to €1.31 a litre from around €1.43 a month ago.

What has precipitated such a slide in the price of crude?  Global economic activity is less energy intensive than it was but the International Energy Agency (IEA) still envisages world oil demand rising by 1.6 million barrels per day (mbd) in 2015, a significant pick up from the 2014 outturn. Weaker than expected growth in China could reduce that estimate but it seems clear that demand is not the main issue. Supply  would therefore  seem to be the driver  of the price collapse, and that is indeed the case, with some estimates putting the excess available in the market in q2 at some 3mbd, an extraordinary figure by historical standards,  and  helping to push OECD oil inventories to record levels.

One factor at work is the continuing rise in non-OPEC supply, which is put at around 1.3mbd in 2015, largely reflecting higher US output, including that from shale. Iraqi supply has also risen substantially over the past year (to record levels) and one might expect Saudi Arabia, the traditional swing producer in OPEC, to reduce production and hence supply from the cartel in order to support price. That has not happened , implying the Kingdom  is adopting a new strategy, perhaps with the aim of  impacting the future development  of non-OPEC supply, particularly from shale. Whatever the rationale the result is that  the world is awash with oil at the moment and few analysts envisage a  significant rise in prices over the next few years. Supply shocks are always possible, of course, which would change the outlook, but in the short term at least consumers are likely to receive another boost to purchasing power via lower fuel costs.

When Debtor Fatigue meets Creditor Fatigue

The euro has always been a politically driven project, and the inevitable economic fault lines that emerged  as it expanded  have been met with a surprisingly strong will on the part of  member governments to maintain the single currency. That determination has surprised markets and often confounded analysts , although  any decisive political action has often emerged from crisis meetings in the early hours of the morning. Decision making in such an environment raises issues of democratic accountability and  risks serious policy errors ( for example the determination to prevent a sovereign default within the EA) and  post-meeting disagreements on what was actually signed off ( see Ireland’s belief that the ESM would be able to retrospectively recapitalize banks). The euro is also now left with fiscal rules  and constraints which are  both extraordinarily complex and lacking in credibility; no one believes that a euro member will be fined for a breach and the Commission has repeatedly backed down when faced with one of the larger member states, notably France .

In the absence of a fiscal union the euro member states have funded bailouts for sovereigns who have lost market access, first directly (as per the first Greek loan) and then through the EFSF. Initially the loans carried relatively high interest rates ( as a form of punishment for fiscal impropriety) but that soon changed as debt sustainability came to the fore, an issue of particular importance to the IMF, which was brought on board  to help design loan programmes and the incorporated conditions.

The Fund’s modus operandi is to  project what it considers to be a sustainable medium term debt ratio  and then derive the required primary fiscal surplus needed to get to that target, given other assumptions including economic growth. Those assumptions can prove spectatularly wrong , and they did in Greece ; the  negative impact on the economy of the required fiscal contraction was much greater than envisaged (  GDP fell 25%, a depression rather than a short lived recession) and  the  forecast €50bn receipts from privatization failed the matrialise ( the figure to date is around €3bn).

Such programmes also assume that creditor governments can deliver the required primary surpluses, however large and sustained they are deemed to be , and ignores the electorates role. Debtor fatigue can set in. In most  countries that has been confined to  (growing) opposition parties but in Greece resulted in a new government pledging an end to austerity, new loans, a debt write down and ongoing euro membership,

Much of that is not in the gift of the Greek authorities to deliver (who knows what electorates can decide )  and that debtor fatigue is now meeting creditor fatigue, which has not been eased by the unusual negotiating stance adopted by the Hellenic Republic, which some characterise as driven by game-theory and others see as inconsistent and bordering on farce. The creditors are not united, it has to be said, with France notably sympathetic to Greek requests, although most , to date at least, appear willing to see Greece exit the euro, such is the lack of faith in Greece’s ability to deliver reforms or to meet the terms of any new loan. Some of that hostility emanates from other debtor countries fearful of the impact of a perceived Greek success on their own political futures- we are all creditors now, it would seem.

Any new money, should it materialise,  will come from the ESM, and that requires a unanimous decision by the Board of Governors, made up of member states. Consequently  any one country can prevent disbursement. In addition, ESM debtors are required to be in a programme which it is envisaged would involve the IMF, so Greece’s default with the fund poses a difficulty.

The Greek crisis has also highlighted the Lender of Last Resort issue . The ECB is not willing to fulfill that role unconditionally and has limited the amount of emergency liquidity the Central Bank of Greece can provide to its banking system. So the ECB, despite its claims to the contrary, emerges as a key player; its actions put pressure on the Greek government to reach an agreement with the creditors and could be the  catalysts for  Grexit, as the pulling of ELA would require Greece to print its own notes to fund the economy.

The markets have shown little in the way of panic reaction to  the Greek saga  and probably feel that some compromise will emerge to keep Greece in the euro, if only because such last-minute deals have been the norm in recent years. Whatever the outcome the stark emergence of debtor and creditor fatigue into the light is a profound  development , and one which is likely to have significant longer term implications for the euro regardless of any short-term fix.