By Claus Vistesen: Copenhagen
It is not secret that the author of this space, at times, has been rather critical towards the ECB. The reason has not been so much for its de-facto inability to amend the situation in the sense that this is an inbuilt characteristic of the system, but more so because of the seeming complacency with which ECB policy makers (with notable exceptions) have viewed the crisis.
However, and with the recent rate meeting one is tempted to conclude that the ECB is now seriously committed to considering alternative measures and also, as it were, drastic measures along the lines of its peers at the Fed, the BOE and the BOJ who have all in their distinct way been engaged in QE for quite some time. In the recent print edition, the Economist provides a fine overview of global central banking in the midst of the current financial crisis; what has changed, whether there will be a "normal" again, and specifically whether central banks will emerge in new clothing, as it were, with new policy targets and objectives. I think these are some important questions since there is indeed a big risk that the edifice of central bank policy which has been built up during the financial crisis may turn out to be anything but temporary. And here I am not talking about the inflationist hobby horse that central bankers may be too slow to haul back the reigns when the economy picks up again, but more so about the fact that whatever trend we will observe in the aftermath won't be anything near the one markets and policy makers expect. Of course, the good old principle of falsification will help on this one as we move forward.
One way in which the ECB has so far differed from its peers can be seen from looking at the first figure in the Economist article where it shown how the ECB has certainly expanding its lending operations (and credit facilities), specifically in the interbank market, it has not yet entered the securities market to buy up debt and equity. Some of us has been surprised by this reluctance which, together with the fact that the ECB has been relatively shy in slashing nominal rates, means that the ECB has appeared lagging in its response. Now, there is nothing wrong with being different and there is certainly nothing wrong with applying different tools to a situation which you genuinely find different. However, as one friend to me pointed out a while back, the ECB's unique, and according to some brave and prudent, response to the crisis is now a liability rather than an asset, and one has to wonder whether that strategy hasn't been subject to revision for a while now.
Indeed, I would be unfair in omitting to mention the fact that the ECB has indeed continued to slash interest rates and that signs have emerged to indicate that the ECB may be more flexible towards non-traditional policy measures. However, if you look at the assessment of the central bank the risk of deflation is still not paramount. At the recent policy meeting where interest rates were lowered by 25 basis points to 1.25 Trichet consequently pointed towards risks being balanced and more specifically how he did not view dis-inflation as being the same thing as deflation. This suggests that the ECB is not yet ready to take steps similar to the ones being taken by the Fed, the BOE and the BOJ.
Trichet, a Man of Principles
The impending comparison in this relation is the one with the Fed and in a recent speech Trichet points towards three, well known, reasons why we should not compare the US and the Eurozone.
The first reason relates to the ECB's focus on the banking sector. Pointing to the fact that banking loans make up a substantially larger part in the Eurozone than in the US (as a percentage of GDP), the chairman defends the focus on easing bank credit issues. Moreover, and as a related point Trichet points towards the importance of small and medium sized companies in the Eurozone (SMEs) and how these companies rely heavily on banks. Far be it from me to disagree with an expert (and I do consider Trichet an expert here), but I would humbly submit the point this is not only a (credit) supply story. At this point it is very much a demand story and how those very same companies need to find investment opportunities beyond maintaining credit to smooth their short term expenses with whatever revenues they might have in prospect.
As a second reason Trichet points towards a higher risk associated with the housing market in the US and thus why the US' asset programs to purchase toxic housing assets should not be replicated in the US. Now, it is true that the wealth effect from housing is considerably higher in the US than in the Eurozone countries at large, but this is also as far as the argument goes. In essence, I really don't know what to say here, and quite frankly this is an embarrassing remark from the president. I mean, doesn't he know that Spain and Ireland are part of the Eurozone? Also the implicit narrative that Europe and the US differs because of the role of housing in the latter is extremely simplified. Take Eastern Europe for example not to mention my own country Denmark. In fact, if there ever was a call for a program to relinquish banks and credit institutions of bad mortgage assets it would be in the case of Spain. Add to this that the crisis exactly turned global the minute BNP Paripas revealed that they too would be suffering subprime related losses and after them a veritable tableau d'horreur has followed.
Thirdly and perhaps most popularly in this discourse, Trichet points to the mitigating effects of a relative high degree of price rigidities in a European context. The point goes that if prices are rigid on the downside, companies will have a harder time lowering wages and prices and thus provoking inflation. We could think of this as a structural hedge against a collapse into deflation and it is basically driven by the fact that if headline inflation did not spark core inflation growth on the up, it won't do it on the downside either. From the point of view of ECB policy however, this argument would be rather inconsistent since we all remember the horror of second round effects that the ECB tried to enshrine into markets as rates were raised back in 2006-07 to counter the increase in headline inflation. In this way, one would assume that such logic applied on the downside too and what is more, it is quite obvious that the deleveraging needed across the global economy need to be deflationary by very nature of the problem at hand. Trichet on the other hand is a man of principles and his remarks, in the context of inflation expectations, during an interview with Süddeutsche Zeitung brought a smile to my face.
But citizens can have full confidence that we will guarantee stable prices over the medium and long term. The 329 million citizens of the euro area are very clever. They would not improve their level of confidence and help restarting the economy if they had the sentiment that we were forgetting our primary medium term goal.
We should not confuse disinflation and deflation. At the moment I am speaking, we are experiencing very low inflation and in the months to come negative inflation due to the decrease of the prices of oil, energy and commodities, before it increases again at the end of the year. This is good for the purchasing power of households and is a correction of the high prices of the past.
It would be interesting to take a poll to see whether those 329 million souls really were as clever as Trichet thinks, whether they are imbued with the kind expectations assumed here, or whether they agree with the ECB overall main objective.
The ECB, a Hydra?
Meanwhile and although the President certainly seems to be keeping his discourse straight, it is not easy to get a handle of what exactly the ECB is planning as we move forward. One classic dichotomy in the context of ECB watching and one which is dearly loved by financial journalists is between Axel Weber, as a hawk, one the one side and e.g. Greek council member Athanasios Orphanides on the other. It is well known that the former on several occasions have argued against slashing the nominal interest rates below 1% whereas the latter has advocated for the ECB to engage in QE-like purchases of assets in the market place. Weber has even been quoted of arguing how the ECB should set a specific floor under how low the nominal interest rate could be slashed.
But, by no means is this only a Saxon-Hellenist skirmish.
Recently, Bloomberg ran a piece in which the Dutch and Belgian council members Noel Wellink and Guy Quaden were quoted of saying that the ECB could (potentially) serve up extraordinary measures as we move forward from the next meeting the 7th of May. On the economic outlook, it is also difficult to get a handle on what the council members think with some arguing how the economy is improving and some, on the other hand, voicing concern over downside risks to prices and economic momentum. Also, on the outlook for deflation, the opinions are many. Trichet is well known to hold the belief that we are not going to see deflation, but only dis-inflation which, in itself, is not detrimental and may even be good for households' disposable income. However, Wellink was also quoted by Bloomberg of saying that the longer this disinflationary process lingers, the higher the risk will be that we get into an unwanted situation.
Adding to the cacophony, executive board member Lorenzo Bini Smaghi recently pointed to the fact (get the speech here) that bringing interest rates close to the zero bound would risk distorting money markets as it could curtail interbank lending. Apart from constituting yet another voice in the wilderness of official ECB opinion makings, this is a point worth considering in the sense that financial institutions might swap what was otherwise a smoothly functioning interbank market for the soothing liquidity tap of the central bank. I think it is important to emphasise though that there is a big difference between short term and long term financing here, where one would assume the central bank to stay exclusively on the short end of the curve. In essence, Mr. Smaghi's speech is a well argued one, and I would not want to leave the impression that I am trying to present a picture of an ECB that is torn to a greater extent than is really the case.
However, it appears that I am not the only picking up the mixed discourses on the radar. Consequently, Bloomberg reporter Simone Meier has a piece which details how Trichet has decided to silence his fellow council members, at least as so far goes the measures taking during the next meeting the 7th of May.
Trichet asked council members last week to refrain from commenting on what new measures the ECB will unveil at its next policy meeting on May 7. Austria’s Ewald Nowotny confirmed the ban today, telling reporters in Vienna officials had been asked “in the name of the President not to talk about details before the May meeting.” Trichet said on April 27 that council members had agreed “not to give any further indications.”
Given the short overview above of the different voices, one can hardly fault the President for this initiative and as David Milleker, chief economist at Union Investment in Frankfurt is quoted of saying;
“They’ve created more confusion than clarity. The entire cacophony didn’t exactly give the picture of a united council in any case.”
This seems to be the point in a nutshell and in an environment where the uncertainty surrounding the ECB's strategy and play book is generally high, the confusion only increases.
Charting a Course
In many ways I think it is natural that the ECB, just as its peers, are finding it difficult to deal with the present circumstances. Nobody ever said that this was easy, but the ECB still leaves an impression that it really does not know what it wants and, more importantly, how it wants to get there. In the recent World Economic Outlook 09, the IMF heads of the description of the European economic edifice with the point that Europe is searching for a coherent policy response. The fund highlights how the severe stress that has built up in the financial system and in the real economy (especially in the context of the CEE) calls for coordination between fiscal and monetary policy. The niggle here is of course that, at present, this is difficulty achieved in a Eurozone, let alone, European context. Moreover, the ECB's sole focus on price stability may be robbing it of looking at more flexible measures although of course, in relation to buying securities in the open market, it is not certain e.g. which countries' bonds it should buy. This is why I, and among others the IMF, have argued that Euro Bonds be considered.
For me, there are two additional issues here. Firstly, I think the ECB is too dogmatic. Sure, you can call me excessively worried about deflation and you can argue that since we are currently sustaining a three month rally things are perhaps not as bad as they seem. However, I still believe that the myopic look on inflation expectations in the aggregate for the Eurozone as well as the idea that price stability in the long run follows naturally from anchoring these expectations constitute a severely miscalibrated compass to navigate the waters in which the economy finds itself at present. There is a fine balance between sticking to one's convention and adjusting to new circumstances, and the ECB is, in my opinion, leaning too much to former. Secondly, I think the ECB and indeed Eurozone policy makers have a responsibility towards on the one hand, the CEE; and on the other keeping the Eurozone in one piece. I think that this responsibility should be conveyed very clearly in speech and action. You can always argue that measures already have been taking, but I think there is good chance (risk) that the whole European economic system needs a serious re-boot on the back of this crisis. Such re-structuring need to be intimately tuned to these two challenges which means that we need to be able to speak openly about them and not narrate anything in the context of one set of aggregate inflation expectations measures. If it is not, then we will truly be all at sea.