Today will be one of the set piece days of economic history as we wait to see if Mario Draghi carries out his promises to ease Euro area monetary policy. Should that be the case then we can expect an increase in QE possibly in several ways ( an extension, a faster rate of purchases, and/or extra assets to be purchased) plus a reduction in the deposit rate below -0.2%. Should he not do so he will have a lot of egg on his face and his version of Forward Guidance where he has mimicked Agent Smith crying “More! More!” in the Matrix series of films will vanish in a puff of smoke. Actually the main problem of Mario and his colleagues at the European Central Bank is that they have raised the expectations bar so high.
If we look for a rationale for this then we see this.
Euro area annual inflation is expected to be 0.1% in November 2015, stable compared with October 2015,
The ECB is about as pure an inflation targeter as we have these days and this is well below the level it has established as what it aims at which is just below 2% per annum and with some spurious accuracy has pointed at 1.97%. If we take this further we see that looking further up the inflation chain is also sending a signal.
In October 2015, compared with September 2015, industrial producer prices fell by 0.3% in the euro area…..In October 2015, compared with October 2014, industrial producer prices fell by 3.1% in the euro area.
To this we can add more factors as the price of a barrel of Brent Crude Oil fell below US $43 per barrel last night and the Bloomberg Commodity Index fell to 80.31 this morning or a new low for this century.
There are several fundamental issues that have to be faced. Firstly inflation targeting under current methodologies did not stop the credit crunch did it? In fact I would argue that the influence of China pushing goods prices lower made consumer inflation mild lulling our establishments into a false sense of security whilst they tuned a blind eye to asset price inflation mostly in house prices. Whilst they stood behind a locked door the burglar climbed in through the window.
Next we have a problem which is not what one would have expected before the credit crunch era. Back then one might have expected negative interest-rates and 60 billion Euros a month of QE asset purchases to generate raging inflation whereas so far we have not seen a lot. Yes there is some in the services sector in the Euro area (1.1%) but even it is below target. If you look at the Euro area inflation figures they are not much different to nations who are no longer increasing monetary easing. What change there has been can easily be explained by the fall in the Euro exchange rate which in trade weighted terms nearly made 100 at the end of 2014 and is 90.7 now. If we look back two years we see that it is some 11.6% lower now than it was then.
Central bankers do not see it like that
Deputy Governor Per Jansson of the Swedish Riksbank has given a speech this morning and told us this.
One of my most important messages is: ”if it’s not broken, don’t try to fix it!”. In our eagerness to bring about change, we can often do more damage than good. The aspect I believe is not broken and therefore does not need fixing is the policy of flexible inflation targeting, which in recent decades has developed into something of an international standard.
Most people consider the credit crunch to be a big deal and many have really suffered which provides its own critique to Per’s “international standard”. There is another oddity here especially if we consider that Per and his colleagues are making an extraordinary effort with negative interest-rates and ever more QE.
I, like my colleagues, have greater sympathy for the argument in the international debate that central banks should raise their inflation targets than for the argument in the Swedish debate that the inflation target should be lowered.
What would raising the inflation target achieve when Per and his colleagues are pretty much “maxxed-out” but still failing to hit the current one? If you think it through logically they are offering a very pessimistic view of the future and giving a damning critique of the implications of their own policy actions.
What could we do?
A starting point was given by Per Jansson earlier.
In the euro area and the United Kingdom, the target is formulated in terms of the HICP index (harmonised index for consumer prices) which does not include costs for owner-occupied housing, only operating costs.
If you put house prices into the consumer inflation numbers then you have a way of addressing a situation where consumer inflation can be benign as it mostly was pre credit crunch whilst asset prices shoot higher. An example of this sort of situation if we stick to the Euro area can be found in Ireland right now. Here is consumer inflation flat-lining.
Prices on average, as measured by the EU Harmonised Index of Consumer Prices (HICP), remained unchanged compared with October 2014.
Well below the 2% annual target and a clear case for Mario to follow the Sugababes and “push the button”. But if we look deeper we see this.
In the month of October, residential property prices rose by 1.6% nationwide. Residential property prices remained up 7.6% on an annual basis.
Actually the whole housing sector is seeing plenty of inflation as in the year to October private rents were rising at an annual rate of 10.3%. Now both property buyers and renters in Ireland must laugh when they are told that there is no inflation in Ireland and even worse if we switch to its own measure (confusingly called CPI) which is at -0.2%.
Ireland is of course a small part of the Euro area but what if ever lower interest-rates fire up its property market one more time? It is of course a muddy picture as prices are now a third below the past bubble peaks but one thing we did learn was that they were unsustainable. It is hard not to wonder about Spain as well.
Today it will be easy to get caught up in the melee especially at 12.45 pm and 1.30 pm but I wanted to pose a challenge to the methodology as much is being done in its name. The whole “deflation” saga which is really a burst of disinflation would be different if we measured inflation more appropriately. As ever there are issues because adding asset prices does not fit the logical mantra of only having consumer expenditure but as I pointed out mathematical and statistical consistency has led us to where exactly?
Also if the main monetary policy mechanism is via the exchange-rate there is the issue of it being a zero-sum game. So who will the ECB export disinflation too? Will it become like a game of tennis with each player hitting the ball back over the net?
It is almost a heresy to say it these days but workers and consumers will welcome the lower good prices central bankers are “battling” and those looking to buy a property will not welcome the higher prices that central bankers call “wealth effects”
A playlist for Mario today
Push the Button by Sugababes
Pump It Up by Elvis Costello and the Attractions
More,More,More by Andrea True Connection
Money For Nothing by Dire Straits
Take the Money and Run by The Steve Miller Band
Money,Money,Money by Abba
Mo Money Mo Problems by The Notorious BIG
And for interest-rates
How low? by Ludacris