The ECB faces a growing policy dilemma

Today I want to look at what was one of the earliest themes of this blog which is that central banks will dither and delay before they reduce their policy easing and accommodation. Or to put it another way they will be too late because they are afraid of moving too soon and being given the blame should the economy hic-cup or turn downwards. Back in the day I did not realise how far central banks would go with the Bank of Japan seemingly only limited by how many assets there are in existence in Japan as it chomps on government bonds and acts as a Tokyo whale in equity markets. Actually it has made yet more announcements today including this from Governor Kuroda according to Marketwatch.

“There is not much likelihood that we will further lower the negative rate” from the current minus 0.1%, Kuroda said in parliament, citing Japan’s accelerating growth.

Last time he said something like that he cut them 8 days later if I recall correctly!

However the focus right now is on Europe and in particular on the ECB ( European Central Bank). as it faces the policy exit question I posed on the 19th of January.

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?

What has changed?

Yesterday brought news on economic prospects which will have simultaneously cheered and worried Mario Draghi and the ECB. It started with France.

The Markit Flash France Composite Output Index, based on around 85% of normal monthly survey replies, registered 56.2, compared to January’s reading of 54.1. The latest figure pointed to the sharpest rate of growth since May 2011.

Welcome news indeed and considering the ongoing unemployment issue that I looked it only a few days ago this was a welcome feature of the service sector boom.

Staffing numbers rose for the fourth consecutive month during February. The increase was underpinned by a solid rate of growth in the service sector,

Unusually for Markit it did not provide any forecast for expected GDP (Gross Domestic Product) growth from this which is likely to have been caused by its clashes with the French establishment in the past. It has regularly reported private-sector growth slower than the official numbers so this is quite a change.

Next up was Germany and the good news theme continued.

The Markit Flash Germany Composite Output Index rose from January’s fourmonth low of 54.8 to 56.1, the highest since April 2014 and signalling strong growth in the eurozone’s largest economy. Output has risen continuously since May 2013.

The situation is different here because of course Germany has performed better than France in recent times illustrated by its very different unemployment rate. I note that manufacturing is doing well as it benefits from the much lower exchange rate the Euro provides compared to where any prospective German mark would be priced. Markit is much more willing to project forwards from this.

The latest PMI adds to our expectations that economic growth will strengthen in the first quarter to around 0.6% q-o-q, marking a strong start to 2017.

Whilst these are the two largest Eurozone economies there are others so let us add them into the mix.

“The eurozone economy moved up a gear in February. The rise in the flash PMI to its highest since April 2011 means that GDP growth of 0.6% could be seen in the first quarter if this pace of expansion is sustained into March.

There are actually two cautionary notes here. The first is that these indices rely on sentiment as well as numbers and as they point out March is yet to come. But the surveys indicate potential for a very good start to 2017 for the Eurozone.

As the objectives of central banks have moved towards economic growth there is an obvious issue when they look good and it is to coin a phrase “pumping up the volume”.

Also there was a hopeful sign for a chronic Euro area problem which is persistent unemployment in many countries.

February saw the largest monthly rise in employment since August 2007. Service sector jobs were created at a rate not seen for nine years and factory headcounts showed the second-largest rise in almost six years.

What about inflation?

Just like it fell more quickly and further than the ECB expected it has rather caught it on the hop with its rise. The move from 1.1% in December to 1.8% in January means it is just below 2% or where the “rules based” ECB wants it. There is an update later but even if it nudges the number slightly the song has the same drum and bass lines. Indeed yesterday’s surveys pointed to concerns that more inflation is coming over the horizon.

Inflationary pressures meanwhile continued to intensify. Firms’ average input costs rose at the steepest rate since May 2011, with rates accelerating in both services and manufacturing. The latter once again recorded the steeper rise, linked to higher global commodity prices, the weak euro and suppliers regaining some pricing power amid stronger demand.

In the past such news would have the ECB rushing to raise interest-rates which leaves it in an awkward position. The only leg it has left to stand on in this area is weak wage growth.

Asset prices

Mario Draghi’s espresso will taste better this morning as he notes this.


Although even the espresso may provide food for thought.

Oh I don’t know…Robusta coffee futures creeping back towards 5-1/2 year highs

That pesky inflation again. Oh sorry I mean the temporary or transient phase!

As to house prices there is a wide variation but central bankers always want more don’t they?

House prices, as measured by the House Price Index, rose by 3.4% in the euro area and by 4.3% in the EU in the third quarter of 2016 compared with the same quarter of the previous year.

Of course should any boom turn to bust then the rhetoric switches to it was not possible to forecast this and therefore it was a “surprise” and nobody’s fault. The Bank of England was plugging that particular line for all it’s worth only yesterday.

The Euro

Much is going on here and it has been singing along to “Down, Down” by Status Quo again. For example it has moved very near to crossing 1.05 versus the US Dollar this morning which makes us wonder if economists might be right and it will reach parity. Such forecasts are rarely right so it would be its own type of Black Swan but more seriously we are seeing a weaker phase for the Euro as it has fallen from just over 96 in early November 2016 to 93.4 now. Here economists return to their usual form as this has seen the UK Pound £ nudge 1.19 this morning or further away from the parity so enthusiastically forecast by some.

A factor in this brings us back to QE and ECB action. A problem I have reported on has got worse and as ever it involves Germany. The two-year Schatz yield has fallen as low as -0.87% as investors continue to demand German paper even if they have to pay to get it. This is creating quite a differential ( for these times anyway) with US Dollar rates and thereby pushing the Euro lower.


There are obvious issues here for the ECB as it faces a period where economic growth could pick-up which is of course good but inflation will be doing the same which is not only far from good it is against its official mandate. It does plan to trim its monthly rate of bond buying to 60 billion Euros a month from 80 billion but of course it still has a deposit rate of -0.4%. Thus the accelerator is still being pressed hard. But as we note that the lags of monetary policy are around 18 months then it may well find itself doing that as both growth and inflation rise. Should that lead to trouble then a so-called stimulus will end up having exactly the reverse effect. Yet the consensus remains along the lines of this from Markit yesterday.

No change in policy
therefore looks likely until at least after the German
elections in September.




13 thoughts on “The ECB faces a growing policy dilemma

    • Hi DoubtingDick

      An interesting point. Does this mean that the technocrat central bankers are better at combining the political and economic cycles? And if so is that why they got control over so much economic policy?

  1. Shaun, a very interesting assessment and collection of not unpleasant challenges. Similar to the UK in that we have buoancy in real estate and jobs but persistent inequality, homeless and short termism in every dimension you can fathom. As you say its stiĺl going to be pedal to the metal. Election politics and security of incumbent leaders predominate all economic levers.

    It seems that countering “populism” is causing those in charge to cling ever stronger to their macro tools in desperate charge to prove they can show some benefit regardless of long term downsides.

    Im with you. more more more until past all 2017 election results… but France could upset the established wisdom… quite early in the year.

    • Hi Paul

      I do wonder about the “populism” label thrown around. Dies that mean a democratic vote you do not like? There is an elitist patrician feel to that which is different to simply disagreeing with policies because you voted for other choices.

  2. It is ironic that you try to avoid politics, as (just see first two comments above) economics is taking a distant second place to politics as the establishment desperately tries to keep its seat at the head of the table. There is a lot of squirming, as they pretend to love democracy, while actually hating popular uprisings…
    I am afraid that the ECB is in an impossible place as a result. It either has to:
    1. Stick to its mandate, raise rates, stop QE and watch its board be fired for its pains; or
    2. Just carry on fudging everything in line with the politicians’ wishes.
    I wonder which it will do…the BoE is already “looking through” inflation and no doubt our European friends will be buying the same set of glasses.
    As mentioned yesterday, given the annual set of elections within the EU, genuine ECB independence will be rare and fleeting.

    • Hi James

      There is a problem which has two drivers. Firstly political establishments have left more and more economic policy to their central banks or at least they have as long as they continue to ease policy! Central bankers have emerged from the background to take centre stage like politicians themselves. Neither is especially healthy in my view.

  3. You say that the ECB has a dilemma with rising growth and rising inflation potentially being in breach of its mandate which is correct but it already has issues within the EZ which are in egregious breach of the stability rules, not the least of which is the huge surplus on German BOP which has gone unpunished for some time. The breach of the rules is particularly stark because the surplus is clearly and is truly structural and will remain while Germany is part of the EZ.

    The ECB has an impossible job in a context that can never work and the last thing it wants is rules that it actually has to follow. Draghi will do like the BOE and ignore any spike in inflation, regarding it as just that: a spike. If the EZ had been that bothered about rules it would have failed long ago and it’s the absence of such that will spin it out a little more.

    BTW I saw your piece on TipTV; very good.

    • I think that word “rules” has to go into Shaun’s lexicon. I would define “rules” as:
      1. An inconvenience to be ignored when in the context of German balance of payments, Italian debt, French deficits; or, alternatively
      2. Something sacrosanct and never to be broken when some minor country, such as Greece, gets into trouble.

  4. Hi Shaun
    Thank you for today’s piece
    regarding all the ongoing insanity.
    Jackson Browne lyrics are
    very apt, and check out Ry Cooder.


  5. Hallo Shaun, having followed Markit predictions and PM indices closely for some years now I have now concluded that their only use is as confirmation of the present situation and should never be used to try to forecast.

    Currently the EZ and EU, in fact the G7 countries look good for growth through 1st and maybe 2nd quarters but I’m looking at a soft patch all round in the Summer corresponding with growing liquidity problems which may elongate through the rest of the year, Can’t say much more until I receive more data except I can confirm given monetary trends at end 2015, I’m expecting an expanding inflation spike but interestingly and much less well known, I’m also expecting steadily increasing Core inflation through 2017 and probably on into 2018, which is what the CB’s are always bleating about. If my prediction is right, as we move through the second quarter and into the third the CB’s ,ECB included, will find it more difficult to look through this inflation as their beloved core begins to spike too.

    The rational thing for the ECB to do now is absoloutely nothing and wait for more data. If inflation and particularly core inflation continues increasing then, despite collapsing narrow money it should raise rates and the EZ and EU will likely go through a stagflationary phase particularly as, like the survey I now also see a real commodity recovery although nothing like the dizzy heights of the past. This time around I think it’s different as the ECB’s all important Core inflation measure is likely to put on a good increase which may just provide enough impetus for them to do the right thing (although it will taste bad in the early months). A dilemma indeed, but, that’s what they’re paid the big bucks for.

    • Hi Noo2

      Back in the early days of the credit crunch PMIs got themselves a good name but that as you say has eroded. It is intriguing they are upbeat on France as they are usually in the other side of the coin so I am particularly keen to see what happens there.

      If you allow for the leads and lags in monetary policy then with your view as expressed here then the central banking response should be to wind down QE much more quickly and get interest-rates out of negative territory and then wait to see what happens next.

      • I think we have different views of money supply leads and lags. As you know text books say 6 months for narrow money, I say 6 – 12 months. From my perspective action now would be premature – if growth picks up again in late summer/early Autumn, which it may as there was a spike in narrow money supply in late summer 2016 then nominal growth may outstrip nominal inflation and acting now would result in overheating and then of course a crash with falling output accompanied by rising inflation and unemployment. If the second growth pulse does not materialise then raising rates and cutting QE will result in stagflation which I prefer to falling output and employment alongside increasing prices.

        I still feel more data is required before they do anything.

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