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.

ECB Traversing outer limits of Policy

The ECB has travelled a long way in its thinking over the last few years, and following the latest round of measures is now at the outer limits of monetary policy, with little left in its armoury. Indeed, we may be moving closer to the point where European policy makers decide that putting all the pressure on monetary policy is a mistake, and that fiscal policy has to be more active when faced with a balance sheet recession and its aftermath.

Inflation in the euro area has been below the ECB’s 2% target for some time and Draghi has often emphasized the fragile nature of the limp economic recovery but the past month has seen a much more negative perspective emerge, as crystallised in the Bank’s economic projections; growth is expected to remain below 2% for the next three years and inflation is forecast to rise to just 1.4% in 2016 from 0.7% this year. Deflation is not seen as likely but such a prolonged period of low inflation is seen to carry  the risk that expectations of sub-2% inflation become embedded.

The ECB can only directly influence very short term interest rates ( the market determines longer rates) and Europe depends heavily on bank credit to finance private sector spending ( as opposed to bond financing) so any policy levers are largely dependent on the banking sector as the transmission mechanism, with the added complication that lending rates are much higher in some parts of the zone than others. The Bank tried to address that fragmentation by providing 3-year cash to the banks in late 2011 but over half of that has been repaid and many banks used it to fund the purchase of government debt, with the result that bank lending to non-financial corporations in the euro area is still contracting. That is due in part to the economic cycle ( demand for loans is low) but the ECB has copied the Bank of England’s  Funding for Lending scheme in seeking to influence the supply of credit  via the  provision of  funds aimed directly at the private sector. Under the targeted scheme (TLTRO)   euro area banks can access funds for up to four years, starting in September, at an initial rate of 0.25%, with an initial limit of some €400bn (7% of the outstanding loan stock ex mortgages) implying a figure in excess of €5.5bn for Irish banks given the €78bn outstanding in loans to non-financial firms (the figure could be higher if one includes personal debt ex mortgages). Draghi talked about monitoring the loans but at first site the penalty for not lending to the private sector is early repayment so it is not clear how much of a stick exists alongside the carrot. Further tranches can be drawn down depending on meeting benchmark targets on net credit growth.

The UK scheme did not have a huge impact and  it remains to be seen whether demand for loans will pick up particularly in depressed economies. Banks are also due to repay some €500bn of the remaining 3-year funding although the ECB has also decided to stop sterilizing the bonds purchased under the SMP, meaning it will no longer drain the equivalent amount of money from the system. The buying of private sector debt, via Asset Backed Securities, is also on the cards, although that will take some time to organise and the market there is small.

As noted the ECB can directly affect short rates and it cut the main refinancing rate by 10 basis points to 0.15%, which  will bring some modest gains to anyone on  a tracker loan and to banks borrowing from the ECB. Lower rates may also put some downward pressure on the currency on the FX markets and to aid in that the ECB cut its deposit rate to negative territory (-0.1%) and will supply as much short term liquidity as banks demand at a fixed rate out till the end of 2016. This puts some flesh on the pledge to keep rates at current levels for an extended period and seeks to influence longer term rates in the market. The euro had weakened in the weeks before the ECB meeting in early June as traders built up  short positions in anticipation of negative rates, but has not fallen further, at least as yet, highlighting that measures that are seen to reduce fragmentation in the euro area often serve to bolster the currency.

The forward guidance issued by the ECB also now excludes any reference to even lower rates and Draghi explicitly stated that we are at the end of the line in terms of rate reductions. Consequently, the  main weapon the ECB has left is full QE, but that is unlikely to have much affect on euro domestic demand given the importance of banking credit. Hence the TLTRO but if that does not work ( and it will take some time anyway for any impact to be felt) the conclusion has to be that fiscal policy may be revisited, with the current conventional wisdom on the need for debt reduction overturned in favour of fiscal expansion. That may be a long shot now but who would have predicted  a few year ago an ECB Funding for Lending scheme, forward guidance and a refinancing rate of 0.15%?