There is much to consider in the current financial market turmoil and as central banks are such major players today there is much to consider for them too. They have slashed interest-rates and many have expanded their balance sheets considerably via the use of QE (Quantitative Easing) yet we are where we are. Many will be wondering if the current indigestion in financial markets has been caused by a single 0.25% interest-rate hike by the US Federal Reserve. Only a couple of weeks or so ago the Open Mouth Operations of the US Fed were promising another four of those in 2016 but that looks like another mirage right now. This returns us to the long-running junkie culture theme of this blog where the continual interventions of central banks have left financial markets and to some extent economies dependent on them. On that subject let me address the words ( yes more OMO! ) from Mario Draghi of the ECB last night.
What did Mario Draghi say?
In what is becoming a familiar theme for central banking speeches Mario opened by blaming foreigners. There is an obvious catch with that if everyone does it.
The euro area has started the New Year facing two opposing forces: a strengthening domestic economy and a weakening global one.
What is Italian for “Johnny Foreigner” please? The detail was interesting as well.
At home, the recovery is proceeding, with consumption as the main driver. That is being supported by our accommodative monetary policy, falling energy prices and a neutral fiscal policy. Employment is rising, up by over 2 million people compared with the trough in 2013.
There is good news for the Euro area economy which has improved as we have regularly discussed and there are 2 million clear reasons to welcome that. However Mario has contradicted himself as the “falling energy prices” have been driven by the foreign events he has just blamed. Also you may note what is a savaging of the Euro area political class and establishment in “a neutral fiscal policy”. Or you can look at it as Mario taking all the credit for himself.
President Draghi opens fire here with a misrepresentation and an odd connection.
The ECB has a central role to play in supporting confidence. We do that by fulfilling our price stability mandate: an inflation rate of below, but close, to 2%.
The misrepresentation is the use of a 2% annual inflation rate as plainly 0% would be price stability as language gets twisted again. Also there is the rather odd idea that a number which was picked out of thin air in some way gives “confidence”! Next came an attempt to hide a rather awkward confession.
With inflation already low for some time, we saw a danger that a continued period of low inflation – even if oil-driven – might destabilise inflation expectations and become persistent.
That is a description of failure by the ECB and yet we are told this.
And we chose to respond by recalibrating the APP because we have ample evidence that it works.
He means the Asset Purchase Program by APP and he continues with the emphasis being mine.
Since the middle of 2014, when we launched our credit easing package, bank lending rates have fallen by 80 basis points for the euro area, and by between 100 and 140 basis points in the countries hit hardest by the crisis. To put that in perspective, to have a similar impact on lending rates with conventional policy would’ve required a one-off rate cut of 100 basis points.
The problem with in effect singing along with last summers hit cheerleader is that you immediately hit trouble. After all Mario Draghi has just confessed that the perceived inflation problem has just got worse! If you re-read his quote he has just told you that not only has 60 billion Euros not worked in that regard but a 1% interest-rate cuts would not have worked either. This poses two sorts of problems. Firstly if he has effectively cut interest-rates by 1% what was he doing cutting them by 0.1% in December? Secondly he is confessing that interest-rate cuts are unlikely to meet the inflation target. This sits very uncomfortably with this bit.
Overall, it’s clear that the impact of the APP on confidence, credit and the economy has been substantial.
Also let’s face it the sentence below is a description of what has not happened in the Euro area since its inception.
Confidence comes from every party fulfilling its mandate.
What is the real problem?
Mario is desperate to tell us that low inflation is a bad idea presumably hoping we will forget the other parts of his speech where it has helped the economy. But as we progress we get to the true issue and it is the worst four letter word in the economic landscape right now, debt.
For example, if euro area inflation were to undershoot our baseline by just 1 percentage point each year for the next five years, it would increase the private debt ratio by around 6 percentage points. That might not sound like a big figure. But, over five years, it’s equivalent to €700 billion in extra debt for firms and households at a time when we should be aiming to reduce debt.
So at the current speed that is nearly a years worth of QE or APP or more than it has done so far as the total is 530 billion Euros.
The subject of debt and the banks is an intertwined one of course. Mario Draghi assures us that things can only get better.
And thanks to the creation of the Single Supervisory Mechanism (SSM) and the comprehensive assessment of banks’ balance sheets, banks are actually stronger now than they were a few years ago. Capital ratios for euro area banks have risen from around 8% in 2007 to close to 14% today. In other words, the risks are currently falling, not rising.
This has already led to some discussion about the problems of Deutsche Bank whose share price fell by over 5% yesterday after previous falls. Also there is the problem of banking in Mario’s home country Italy where we see this so far today.
#Italy | *MONTE PASCHI HALTED, LIMIT DOWN AFTER FALLING 8.7% IN MILAN (h/t @moved_average )
But apparently that is not a sign of instability.
What’s more, though low-interest rates can encourage risk-taking, there are no warning signs of serious financial instability.
Many might say look at home Mario as the subject analysed in the article linked to below was the hot topic on Bloomberg television this morning.
Yet in other areas there are opposite signs of trouble.
That’s not to say we don’t see pockets of exuberance, for example in some housing markets.
However in a complete reversal of economic history up to this point we will apparently see this.
And let me also add that if we did at some point see a generalised overheating in the economy, it’s never a problem for central banks to withdraw excess liquidity.
Never a problem?
A Space Oddity
Mario Draghi tells us that criticisms I have expressed are false.
Others warned that we were exposing ourselves to heavy losses from expanding our balance sheet and accepting lower-quality collateral. In fact we haven’t had a single loss.
He seems to have forgotten that by buying ever more so far he has enforced this by doubling down! The Greek debt either has gone to the ESM (European Stability Mechanism) or is on its way there and 60 billion Euros per month of other Euro area debt is being bought by him apparently for an ever longer period! How could he have a loss as he is preventing it?
Yesterday and today have highlighted that the beneficial half-life of Open Mouth Operations for equity markets has shrunk. Mario had a go last Thursday and last night yet markets have fallen yesterday and today. Yet if we move to government bond markets we have seen more signs of safe haven buying. The two-year yield of Germany has fallen to -0.46% and the five-year yield to -0.24% which are both records. Just as a reminder this means that investors are paying to hold German sovereign debt and by a record amount which gives us a different song to the “things can only get better” of Mario Draghi.
There is also the issue of the Euro exchange rate which is not following the hints of President Draghi. He would like it to fall further but it has got rather becalmed in spite of his moves in December and his current hints teases and promises. Some of that is due to the weaker path of the UK Pound £ but the Euro has in general stopped falling.
President Draghi has lost himself in a land of confusion as he alternates between describing his policies as a success and a failure. If they are working so well why has he added more and then so quickly making even more promises. He has become like Agent Smith in The Matrix series of films. The monetary taps are open interest-rates have been slashed to negative territory and yet if we move from price to quantity there must be clear issues with how much Italian banks for example are willing to lend.
Yet if we step back we see that employment has risen and the Euro area is seeing economic growth which of course are interrelated. This is a clear improvement but if we look at the latest business surveys the famous quote from Muhammed Ali comes to mind “Is that all you’ve got (George)” as we note the extraordinary monetary effort.
The survey data are consistent with GDP rising at a steady quarterly rate of 0.3-0.4% at the start of the year.