Central banks face an inflation inspired policy exit dilemma

Later today the ECB ( European Central Bank) will announce it latest policy decisions on interest-rates and extraordinary monetary policy such as QE ( Quantitative Easing) asset purchases. I am not expecting any grand announcement of change as this came last time if you recall.

As regards non-standard monetary policy measures, we will continue to make purchases under the asset purchase programme (APP) at the current monthly pace of €80 billion until the end of March 2017. From April 2017, our net asset purchases are intended to continue at a monthly pace of €60 billion until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.

Ever since then they have been keen to tell us this is not a taper and the formal minutes showed quite a bit of debate on the matter.

either to continue purchases at the current monthly pace of €80 billion for an additional six months, or to extend the programme by nine months to the end of December 2017 at a monthly pace of €60 billion. In both cases, purchases would be made alongside the forthcoming reinvestments starting in March 2017.

I think they made the right choice to reduce the size of the monthly purchases but do not see why they guaranteed it to the end of the year apart from them being afraid of markets getting withdrawal symptoms.

What are these policies supposed to do?

Back in 2015 the ECB issued a working paper on how it thought QE worked.

First, via the direct pass-through channel, the non-standard measures are expected to ease borrowing conditions in the private non-financial sector by easing banks’ refinancing conditions, thereby encouraging borrowing and expenditure for investment and consumption.

Actually this is a generic explanation of the claimed benefits of extraordinary policies and applies in some ways more directly to the TLTROs (Targeted longer-term refinancing operations) . As ever it is the “precious” which is considered to be the main beneficiary.

this encourages banks to increase their supply of loans that can be securitised, which tends to lower bank lending rates.

Of course this can have plenty of effects and let us remind ourselves that house prices in Portugal are rising at an annual rate of 7.6% which is the “highest price increase ever observed” as I analysed on Monday. Let us then move on by noting that officially this will be recorded as a “wealth effect” and will benefit the mortgage books of the troubled Portuguese banking sector whereas for first-time buyers and those looking to move up the property ladder it is inflation. Although the Euro area measure of inflation ignores this entirely.

In December 2016, the annual rate of change was 0.9% (0.5% in the previous month)

We note that even so it is rising and move on.

Next we have this effect.

Second, via the portfolio rebalancing channel, yields on a broad range of assets are lowered. Asset purchases by the central bank result in an increase in the liquidity holdings of the sellers of these assets. If the liquidity received is not considered a perfect substitute for the assets sold, the asset swap can lead to a rebalancing of portfolios towards other assets.

This is how the 0.1% and indeed the 0.01% benefit as they of course by definition have plenty of assets overall. It is also part of the road where 8 people have as much wealth as the bottom half of the world’s population.

There is supposed to be a third announcement effect but it is hard not to have a wry smile at the claims made for Forward Guidance when you read this.

It has been found to be muted in the United Kingdom, moderate in the euro area and highly uncertain in the United States,

Inflation Target

Here we have the definition of it.

The primary objective of the ECB’s monetary policy is to maintain price stability…….The ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

There is clear abuse of language here as the Euro area his in fact had price stability with inflation ~0% in recent times but the ECB does not want this. Back in the day a past ECB President ( Trichet) gave us a rather precise definition of 1.97% in his valedictory speech.

Where are we now?

Yesterday there was something of a change.

Euro area annual inflation was 1.1% in December 2016, up from 0.6% in November. In December 2015 the rate was 0.2%.

So the broad sweep of higher inflation in December around Europe continued as we saw quite a jump. Some of that may unwind but 2017 is likely to see a higher and higher theme as we note transport for fuel rising at an annual rate of 6% and vegetables at 5.2% so exactly the wrong sort of inflation for consumers and workers. There is only one country now with disinflation which is Ireland but more than a few clustering around 2% including Germany at 1.7%. It makes you think if we move to today’s house price update how statisticians in Ireland can report disinflation with house prices rising at an annual rate of 7.1%. Also we seem set to see a phase of more general inflation worries from Germany which has house price inflation of 6.2%.

Exit strategies

Back in December 2009 my old tutor at the LSE Willem Buiter wrote this.

The large-scale ex-ante and ex-post quasi-fiscal subsidies handed out by the Fed and to a lesser extent by the other leading central banks, and the sheer magnitude of the redistribution of wealth and income among private agents that the central banks have engaged in could (and in my view should) cause a political storm.

He was not aware then of the scale of what he calls fiscal subsidies which have been handed out by the Bank of England, Bank of Japan and the ECB since amongst others. But here is his crucial conclusion.

Delay in the dropping of the veil is therefore likely.

The prediction that they will delay exiting from monetary policies such as QE is spot on in my view and is where we are now. We have seen a PR campaign for example by Bank of England Governor Mark Carney as he sings along to Shaggy on distributional issues concerning wealth and also income.

She saw the marks on my shoulder (It wasn’t me)
Heard the words that I told her (It wasn’t me)
Heard the scream get louder (It wasn’t me)

However I disagree with Willem completely here.

There are few if any technical problems involved in reversing the unconventional monetary policies – quantitative easing, credit easing and enhanced credit support – implemented by central banks around the world as short-term nominal interest rates became constrained by the zero lower bound.

I was never entirely convinced by this line of argument but of course to be fair to Willem the situation now concerning QE is completely different in terms of scale.  Many bond purchases look to be permanent and the UK for example has bought Gilts which mature in the 2060s.


If we look at the overall picture we see that 2017 poses quite a few issues for central banks as they approach the stage which the brightest always feared. If you come off it will the economy go “cold turkey” or merely have some withdrawal systems? What if the future they have borrowed from emerges and is worse than otherwise? We learn a little from what the US Federal Reserve has done but maybe not as much as we might think for two reasons. Firstly whilst it stopped new QE purchases it continues to reinvest maturing purchases from the past. Secondly in terms of the international picture it did so whilst so many others were on the “More.More,More” road as it got a type of first mover advantage.

The Bank of England is in a particularly bad place as it applied more when in fact there were arguments for less ( likely higher inflation) followed by the Bank of Japan which is buying assets so quickly. Accordingly I wait to see if we get any hints of future moves from the ECB today.

Oh and do you note that the official rationale for QE type policies never seems to involve confessing you would like a lower value for your currency?

Me on TipTV Finance




18 thoughts on “Central banks face an inflation inspired policy exit dilemma

  1. Inflation, inflation, inflation. That’s all I read about these days. Seems people have caught the inflation bug. What’s going on? All I heard for the last few years that there was no inflation and now we have it. As perhaps the only economist (along with Steve Keen) that I think I might understand I appreciate your articles. Thanks for taking the time to write them.

    • TJ , inflation , like rust , never sleeps

      oh you can calculate it in a way to make it look small ( CPI ) but if you follow your own records you’ll see its quite quite large

      also core inflation the Big Banks and CB like does not include food , fuel and housing

      so long as yer ipad is getting cheaper is all they measure

      meantime in the real world ……


      • Hi Forbin

        Mario Draghi was indeed on the case today.

        ” This reflected mainly a strong increase in annual energy inflation, while there are no signs yet of a convincing upward trend in underlying inflation. Looking ahead, on the basis of current oil futures prices, headline inflation is likely to pick up further in the near term, largely reflecting movements in the annual rate of change of energy prices. However, measures of underlying inflation are expected to rise more gradually over the medium term,”

        So they panic if oil priices drive inflation down but it does not matter the other way!

        Happy National Popcorn Day.

  2. They need to take lessons from Deutsche banks! Have a look at the article on Bloomberg entitled ‘How Deutsche bank made a E367 million loss disappear’. What a bunch of crooks and the main perpetrator appears to have escaped justice.

    • Hi Pavlaki,

      I posted a link to that article below … either our comments crossed each other like ships in the night or I am blind and didn’t see yours.

  3. Great blog, Shaun, as usual.
    Speaking about never admitting that you would like to see a lower currency, the Bank of Canada left its overnight rate at 0.5% yesterday, as expected, but the loonie dropped by more than a cent after Governor Poloz’s comments at the press conference following the release of the Monetary Policy Report, finishing the day at $0.7537. The MPR itself raised the forecast for real GDP to 2.1%; in its October report, before the US presidential election it had forecast 2.0% growth. For some reason, the Bank of Canada forecasters chose to factor in the beneficial impact of a fiscal stimulus from the incoming Trump administration, while ignoring the negative impact of its “protectionist tilt”, identified as a threat to the inflation outlook in the report. But then when asked how the Bank might respond if US protectionist measures hurt Canada, Poloz responded: “Yes, a rate cut remains on the table”. I am not sure how serious he is about this, but he seems to enjoy talking the loonie down just as much as Carney enjoyed talking it up. Every MPR, like this one, refers to “the waning of exchange-rate passthrough” but it never really goes away as Poloz is always pushing the loonie lower still.
    This was the first MPR with the three new dysfunctional core measures that have replaced CPIX as the Bank’s operational guide. In his opening statement, Poloz said “we would expect all inflation measures to converge sustainably on 2 per cent in the latter part of our projection horizon”. This would seem to be about as likely as sighting a unicorn. You have to go back to two months in 2011 to find a month where the three new core measures and CPI All-items averaged to 2.0%. In the earlier one, July 2011, the CPI All-items inflation rate was 2.7%, and the target rate average came from the low core inflation measures. There are no forecasts provided for any of three new core measures, as there were for the previous operational guide, CPIX. CPI All-items inflation is forecast at 2.0% for 2018Q4.

    • Hi Andrew

      You comment made me read the Bank of Canada MPR and it does spend quite a lot of time on a US fiscal stimulus for something that only would change Canada’s GDP by 0.1%. Also this bit is odd in a way.

      “That said, our updated projection—which, I should remind you, is more conditional than usual—shows the Canadian economy experiencing above- potential economic growth for the next several quarters……..Looking ahead, Governing Council expects inflation to move up to close to 2 per cent in the near term, mainly because of firmer energy prices. More importantly, our growth outlook would imply a narrowing of the economy’s excess capacity over the course of 2017 and into 2018.”

      So he should be considering an interest-rate rise should the Loonie weaken and maybe anyway.

    • Even though I used to work in an investment bank, I’m staggered at the
      1. Blatant disregard for any rules/morality
      2. Complete inability or unwillingness of senior management to apply the brakes to this sort of behaviour.
      Does anyone think that it’s changed today?

  4. CBs encourage loan securitisation? Is that a rerun of the last decades liars loans swindle? Fraud on a massive scale…. And no punishment for bankers

    • Hi ExpatInBG

      I will not be holding my breath for any real punishment in the Deutsche Bank BMPS scandal quoted by Jim and Pavlaki above. Also I noted as I looked at the numbers that Bulgaria has annual consumer disinflation (-.0.5%) but with house price inflation accelerating to 8.8%.

      • Hello ExpatInBG and Shaun. Eurostat updated its OOHPI series for 2016Q3 today. As you say, Shaun, house prices have been going up bigtime in Bulgaria, and this has helped propel its OOHPI annual inflation rate from 4.1% in 2016Q2 to 7.0% in 2016Q3. This was the third biggest increase of any of the 25 EEA countries for which OOHPIs were published, after Estonia (8.1%) and Sweden (8.3%).

  5. And just as all this starts to come to a head, I have a leaflet pushed through my door declaring my council, a unitary authority (after the people of the parish stupidly voted for unitary status thinking they would have freedom to what they want without “interference” from central Government and having ignored my warnings at the time that as central funding was gradually removed, which was a feature of Unitary status, our council would be left with no back stop as it would be adrift from Central Government and no longer it’s responsibility if our council messed up but everyone else was convinced our council couldn’t possibly make any mistakes!!!) will lose the last of it’s central funding in 2018.

    The council are already talking about borrowing money to meet the shortfall to finance ongoing services (but not to finance any new start up council organisation that might make a profit to repay the loans being talked about) because “rates have never been so low. Now is the time to borrow”. Presumably our council tax will have to be increased over time to fund the interest payments until we reach a time where maybe 20, 30,40 or 50% of our council tax goes on servicing the debts. Still, no one except me seems to think there is anything wrong with this suggestion or that it could possibly go wrong!!

    Yes, indeed, my council intends to embark on it’s own miniaturised version of fiscal recklessness to add to the barriers that prevent the CB’s from ever really increasing rates..

    Rant over – Beam me up Scotty!!!

    • Hi Noo2

      It would be interesting to find out at what interest-rate your council can borrow at without the backing of central government. It is not alone is facing or considering Council Tax rises.

      “Tory controlled Surrey council to hold referendum on raising council tax by 15% cos of social care crisis” ( BBC)

      • I don’t know Shaun because this is in it’s infancy and I wouldn’t know where tolook, certainly not the council as they won’t have a clue!

        One thing though, is that it owns a lot of land and municipal buildings outright so I guess we’ll be back down the road of securitised borrowing with no thought given to the fact we could end up losing our swimming baths and Town Hall etc, although, as long as the councillors were still in the Town Hall when we lost it I would find that an acceptable outcome!!

    • I don’t know the exact percentage but most councils spend a good proportion on generous pensions for ex-employees and there’s only one way that proportion will go so it will eventually be mostly debt servicing and pensions with salaries for current staff and a tiny bit left over for the services they are supposed to provide…..unless of course they keep putting up council tax!

  6. They are stuck between a rock and a hard place since their QE policies have driven asset prices so high the only way out is to inflate away the underlying debt. I do hope the history books savage those responsible I.e. Greenspan and king for being utter failures. The poor will suffer here.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.