Mario Draghi and the ECB prepare for a change of course next month

After a week where the UK has dominated the headlines it is time to switch to the Euro area.  This is for two reasons.  We receive the latest inflation data but also because a speech from European Central Bank President Mario Draghi has addressed an issue we have been watching as 2018 has developed. We have been waiting to see how he and it will respond to the economic slow down that is apparent. This is especially important as during the credit crunch era the ECB has not only been the first responder to any economic downturns it has also regularly found itself to be the only one. Thus it finds itself in a position whereby in terms of negative interest-rates ( deposit rate of -0.4%) and balance sheet ( still expanding at 15 billion Euros per month ) and credit easing still heavily deployed. Accordingly this sentence from Mario echoes what we have been discussing for quite a while.

The key issue at stake is as follows: are we witnessing a temporary “soft patch” or a more lasting deterioration in the growth outlook?

The latter would be somewhat devastating for the man who was ready to do “whatever it takes” to save the Euro as it would return us to discussions about its problems a major one of has been slow economic growth.

Some rhetoric

It seems to be a feature these days of official speeches that they open with what in basketball terms would be called a head fake. Prime Minister Theresa May did it yesterday with an opening sentence which could have been followed by a resignation and Mario opened with what could have been about “broad based” economic growth.

The euro area economy has now been growing for five years, and we expect the expansion to continue in the coming years.

Of course central bankers always expect the latter until there is no other choice. Indeed he confirms that line of thought later.

There is certainly no reason why the expansion in the euro area should abruptly come to an end.

As we move on we get an interesting perspective on the past as well as a comparison with the United States.

Since 1975 there have been five periods of rising GDP in the euro area. The average duration from trough to peak is 31 quarters, with GDP increasing by 21% over that period. The current expansion in the euro area, however, has lasted just 22 quarters and GDP is only around 10% above the trough. In contrast, the expansion in the United States has lasted 37 quarters, and GDP has risen by 21%.

The obvious point is whether you can use the Euro area as a concept before it even existed?! Added to that via the “convergence” promised by the Euro area founders economic growth should be better now than then, except of course we have seen plenty of divergence too. Also you might find it odd to be pointing out that the US has done better especially as the way it is put which reminds us that for all the extraordinary monetary action the Euro area has only grown by 10%. Even that relies on something of a swinging ball as of course he is comparing with the bottom of the dip rather than the past peak as otherwise the number would be a fair bit weaker. Mario is leaving a bit of a trap here, however, or to be more precise he thinks he is.

How have we got here?

First we open with two standard replies the first is that whilst any growth is permanent setbacks are temporary and the other fallback is to blame the weather.

The first is one-off factors, which have clearly played an important role in the underperformance of growth since the start of the year. In the first half of 2018, weather, sickness and industrial action affected output in a number of countries.

Actually that makes the third quarter look even worse as they had gone by then yet growth slowed. He is on safer ground here though.

Production slowed as carmakers tried to avoid building up inventory of untested models, which weighed heavily on economies with large automobile sectors, such as Germany. Indeed, the German economy actually contracted in the third quarter, removing at least 0.1 percentage points from quarterly euro area growth.

This is another marker being put down because it you are thinking that you might need to further expand monetary policy it is best to try to get the Germans onside and reminding them that they too have issues will help. Indeed for those who believe that ECB policy is essentially set for Germany it may be not far off a clincher.

There is something that may worry German car producers if they are followers of ECB euphemisms.

The latest data already show production normalising.

After all the ECB itself may not achieve that.

Trade

This paragraph is interesting on quite a few levels.

The second source of the slowdown has been weaker trade growth, which is broader-based. Net exports contributed 1.4 percentage points to euro area growth in 2017, while so far this year they have removed 0.2 percentage points. World trade growth decelerated from 5.2% in 2017 to 4.6% in the first half of this year.

Oddly Mario then converts a slow down in growth to this.

We are witnessing a long-term slowdown in world trade.

As we note the change in the impact of trade on the Euro area there are several factors in play. You could argue that 2017 was a victory for the “internal competitiveness” austerity model applied although when we get to the collective that is awkward as the Euro area runs a large surplus driven by Germany. From the point of view of the rest of the world they would like it to reduce although the preferable route would be for the Euro area ( Germany ) to import more.

Employment

Mario cheers rightly for this.

Over the past five years, employment has increased by 9.5 million people, rising by 2.6 million in Germany, 2.1 million in Spain, 1 million in France and 1 million in Italy.

I bet he enjoyed the last bit especially! But later there is a catch which provides food for thought.

 But since 2013 more than 70% of employment growth has come from those aged 55-74. This partly reflects the impact of past structural reforms, such as to pension systems.

Probably not the ECB pension though as we are reminded of “Us and Them” by Pink Floyd.

Forward he cried from the rear
And the front rank died
And the general sat
And the lines on the map
Moved from side to side.

Also whilst no doubt some of these women wanted to work there will be others who had no choice.

The share of women in work has also risen by more than 10 percentage points since the start of EMU to almost 60% – its highest level ever

Put another way this sentence below could fit into a section concerning the productivity crisis.

 In addition, countries that have implemented structural reforms have in general seen a rise in labour demand in recent years compared with the pre-crisis period. Germany, Portugal and Spain are all good examples.

There is a section on wages but Mario end up taking something of an each-way bet on this.

But in the light of the lags between wages and prices after a period of low inflation, patience and persistence in our monetary policy is still needed.

Money Supply and Credit

This is how central bankers report a sustained and considerable slow down in the money supply.

The cost of bank borrowing for firms fell to record lows in the first half of this year across all large euro area economies, while the growth of loans to firms stood at its highest rate since 2012. The growth rate of loans to households is also the strongest since 2012, with consumer credit now acting as the most dynamic component, reflecting the ongoing strength of consumption.

Also the emphasis below is mine and regular readers are permitted a wry smile.

Household net worth remains at solid levels on the back of rising house prices and is adding to continued consumption growth.

Comment

We are being warmed up for something of a change of course in case it is necessary.

When the Governing Council met in October, we confirmed our confidence in the economic outlook………….When the latest round of projections is available at our next meeting in December, we will be better placed to make a full assessment of the risks to growth and inflation.

As if they are not already thinking along those lines! The next bit is duo fold. It reminds us that the Euro area has abandoned fiscal policy but does have a kicker for the future.

To protect their households and firms from rising interest rates, high-debt countries should not increase their debt even further and all countries should respect the rules of the Union.

The kicker is perhaps a hint that there is a solution to that as well.

In conclusion, I want to emphasise how completing Economic and Monetary Union has become more urgent over time not less urgent – and not only for the economic reasoning that has always underpinned my remarks, but also to preserve our European construction………….more Europe is the answer.

There Mario leaps out of his apparent trap singing along to Luther Vandross.

I just don’t wanna stop
Oh my love, a million days in your arms
Is never too much (never too much, never too much, never too much)

Podcast

 

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Slowing growth and higher inflation is a toxic combination for the Euro area

Sometimes life comes at you fast and the last week will have come at the European Central Bank with an element of ground rush. It was only on the 30th of last month we were looking at this development.

Seasonally adjusted GDP rose by 0.2% in the euro area (EA19) and by 0.3% in the EU28 during the third quarter
of 2018,

Which brought to mind this description from the preceding ECB press conference.

Incoming information, while somewhat weaker than expected, remains overall consistent with an ongoing broad-based expansion of the euro area economy and gradually rising inflation pressures. The underlying strength of the economy continues to support our confidence ……..

There was an issue with broad-based as the Italian economy registered no growth at all and the idea of “underlying strength” did not really go with quarterly growth of a mere 0.2%. But of course one should not place too much emphasis on one GDP reading.

Business Surveys

However this morning has brought us to this from the Markit Purchasing Managers Indices.

Eurozone growth weakens to lowest in over two years

The immediate thought is, lower than 0.2% quarterly growth? Let us look deeper.

Both the manufacturing and service sectors
recorded slower rates of growth during October.
Following on from September, manufacturing
registered the weaker increase in output, posting its
lowest growth in nearly four years. Despite
remaining at a solid level, the service sector saw its
slowest expansion since the start of 2017.

There is a certain sense of irony in the reported slow down being broad-based. The issue with manufacturing is no doubt driven by the automotive sector which has the trade issues to add to the ongoing diesel scandal. That slow down has spread to the services sector. Geographically we see that Germany is in a soft patch and I will come to Italy in a moment. This also stuck out.

France and Spain, in contrast, have
seen more resilient business conditions, though both
are registering much slower growth than earlier in
the year.

Fair enough for Spain as we looked at only last Wednesday, but France had a bad start of 2018 so that is something of a confused message.

Italy

The situation continues to deteriorate here.

Italy’s service sector suffered a drop in
performance during October, with business activity
falling for the first time in over two years. This was
partly due to the weakest expansion in new
business in 44 months.

Although I am not so sure about the perspective?

After a period of solid growth in activity

The reality is that fears of a “triple-dip” for Italy will only be raised by this. Also the issue over the proposed Budget has not gone away as this from @LiveSquawk makes clear.

EU’s Moscovici: Sanctions Can Be Applied If There Is No Compromise On Italy Budget -Policy In Italy That Entails Higher Public Debt Is Not Favourable To Growth.

Commissioner Moscovici is however being trolled by people pointing out that France broke the Euro area fiscal rules when he was finance minister. He ran deficits of 4.8% of GDP, followed by 4.1% and 3,9% which were above the 3% limit and in one instance double what Italy plans. This is of course awkward but not probably for Pierre as his other worldly pronouncements on Greece have indicated a somewhat loose relationship with reality.

Actually the Italian situation has thrown up another challenge to the Euro area orthodoxy.

 

Regular readers will be aware I am no fan of simply projecting the pre credit crunch period forwards but I do think that the Brad Setser point that Italy is nowhere near regaining where it was is relevant. If you think that such a situation is “above potential” then you have a fair bit of explaining to do. Some of this is unfair on the ECB in that it has to look at the whole Euro area as if it was a sovereign nation it would be a situation crying out for some regional policy transfers. Like say from Germany with its fiscal surplus. Anyway I will leave that there and move on.

Ch-ch-changes

This did the rounds on Friday afternoon.

ECB Said To Be Considering Fresh TLTRO – MNI ( @LiveSquawk )

Targeted Long-Term Refinancing Operation in case you were wondering and as to new targets well Reuters gives a nod and a wink.

Euro zone banks took up 739 billion euros at the ECB’s latest round of TLTRO, in March 2017. Of this, so far 14.6 has been repaid, with the rest falling due in 2020 and 2021.

This may prove painful in countries such as Italy, where banks have to repay some 250 billion euros worth of TLTRO money amid rising market rates and an unfavorable political situation.

So the targets of a type of maturity extension would be 2020/1 in terms of time and Italy in terms of geography. More generally we have the issue of oiling the banking wheels. Oh and whilst the Italian amount is rather similar to some measures of how much they have put into Italian bonds there is no direct link in my view.

Housing market

If you give a bank cheap liquidity then this morning’s ECB Publication makes it clear where it tends to go.

The upturn in the euro area housing market is in its fourth year. Measured in terms of annual growth rates, house prices started to pick up at the end of 2013, while the pick-up in residential investment started somewhat later, at the end of 2014. The latest available data (first quarter of 2018) indicate annual growth rates above their long-term averages, for both indicators.

How has this been driven?

 In addition, financing conditions remained favourable, as reflected in composite bank lending rates for house purchase that have declined by more than 130 basis points since 2013 and by easing credit standards. This has given rise to a higher demand for loans for house purchase and a substantial strengthening in new mortgage lending.

Indeed even QE gets a slap on the back.

Private and institutional investors, both domestically and globally based, searching for yield may thus have contributed to additional housing demand.

It is at least something the central planners can influence and watch.

Housing market developments affect investment and consumption decisions and can thus be a major determinant of the broader business cycle. They also have wealth and collateral effects and can thus play a key role in shaping the broader financial cycle. The housing market’s pivotal role in the business and financial cycles makes it a regular subject of monitoring and assessment for monetary policy and financial stability considerations.

 

Comment

The ECB now finds itself between something of a rock and a hard place. If we start with the rock then the question is whether the shift is just a slow down for a bit or something more? The latter would have the ECB shifting very uncomfortably around its board room table as it would be facing it with interest-rates already negative and QE just stopping in flow terms. Let me now bring in the hard place from today’s Markit PMI survey.

Meanwhile, prices data signalled another sharp
increase in company operating expenses. Rising
energy and fuel prices were widely reported to have
underpinned inflation, whilst there was some
evidence of higher labour costs (especially in
Germany).

Whilst there may be some hopeful news for wages tucked in there the main message is of inflationary pressure. Of course central bankers like to ignore energy costs but the ECB will be hoping for further falls in the oil price, otherwise it might find itself in rather a cleft stick. It is easy to forget that its “pumping it up” stage was oiled by falling energy prices.

Yet an alternative would be fiscal policy which hits the problem of it being a bad idea according to the Euro area’s pronouncements on Italy.

 

The economy of Spain provides some welcome good news for the ECB

A rush of economic data over the past 24 hours allows us as to follow Sylvia’s “I’m off to sunny Spain”. This gives us another perspective as we switch from the third largest economy ( Italy) yesterday where economic growth has ground to a halt again whereas in the fourth largest it is doing this according to the statistics office.

The Spanish GDP registers a growth of 0.6% in the third quarter of 2018 to the previous quarter in terms of volume. This rate is similar to that registered in the second quarter of the year. The annual growth of GDP stands at 2.5%, a rate similar to that of the quarter preceding.

As you can see two countries which were part of the Euro area crisis are now seeing very different circumstances. At the moment Spain is a case of steady as she goes because quarterly growth has been 0.6% for each of 2018’s quarters so far.

If we back for some perspective we are reminded of the trouble that hit Spain. It did begin to recover from the initial impact of the credit crunch but then the Euro area crisis arrived at economic growth headed into negative territory in 2011-13 peaking at a quarterly decline of 1% at the end of 2013. This was followed by improvements in 2014 such that quarterly growth reached 1.2% in the first quarter of 2015. Since then quarterly growth has been strong for these times varying between the current 0.6% and the 0.9% of the opening of 2017.

So we see that Spain saw the hard times with annual economic growth falling to -3.5% late in 2012 but can rebound as illustrated by the 4.1% of late 2015. Those who have followed my updates on Greece will recall that I often refer to the fact that after its precipitous and sustained decline it should have had in terms of economic recovery a “V-shaped” rally in economic growth. Well Spain gives an example of that whereas Greece has not. If we switch to yesterday’s theme Spain is a much happier case for the “broad-based economic expansion” claims of Mario Draghi and the ECB because whilst economic growth has slowed it is still good and is pulling the Euro area average higher.

Inflation

If we continue with the mandate of the ECB we were told this by Spain statistics yesterday.

The annual change in the flash estimate of the CPI stands at 2.3% in October, the same registered in September
The annual rate of the flash estimate of the HICP is 2.3%.

So inflation is over target and has been picking up in 2018 with the current mix described below.

In this behavior, the decrease in the prices of electricity stand out, compared to the increase
registered in 2017, and the rise in gas prices.

From the point of the ECB if we look at inflation above target and the economic growth rate and point out that it is withdrawing the stimulus provided by monthly QE. However the water gets somewhat choppier if we look at another inflation measure.

The annual variation rate of the Housing Price Index (HPI) in the second quarter of 2018 increased six tenths, standing at 6.8%. By type of housing, the variation rate of new housing stood at 5.7%, remaining unchanged
as compared with the previous quarter. On the other hand, the annual variation of second-hand housing increased by seven tenths, up to 7.0%.

The first impact is the rate of annual change and this is more awkward for the ECB as it is hard not to think of the appropriateness of its -0.4% deposit rate for Spain. Its impact on mortgage rates especially when combined with the other monetary easing has put Spain on a road which led to “trouble,trouble,trouble” last time around. For those of you wondering what Spanish mortgage rates are here via Google Translate is this morning’s update.

In mortgages on homes, the average interest rate is 2.62% (4.3%) lower than August 2017) and the average term of 24 years. 59.8% of mortgages on housing is made at a variable rate and 40.2% at a fixed rate. Mortgages at a fixed rate they experience an increase of 3.9% in the annual rate. The average interest rate at the beginning is 2.43% for mortgages on variable-rate homes. (with a decrease of 5.5%) and 2.99% for fixed rate (3.1% lower).

As fixed-interest mortgages are only around half a percent per annum higher the number taking variable-rate ones seems high. However I have to admit my view is that Mario Draghi has no intention of raising interest-rates on his watch and the overall Euro area GDP news from yesterday backs that up. Of course we are switching from fact to opinion there and as a strategy I would suggest that any narrowing of the gap between the two types gives an opportunity to lock in what are in historical terms very low levels.

Labour Market

The economic growth phase that Spain has seen means we have good news here.

The number of employed increases by 183,900 people in the third quarter of 2018 compared to the previous quarter (0.95%) and stands at 19,528,000. In terms seasonally adjusted, the quarterly variation is 0.48%. Employment has grown by 478,800 people (2.51%) in the last 12 months.

Higher employment does not necessarily mean lower unemployment but fortunately in this instance it does.

The number of unemployed persons decreased this quarter by 164,100 people (-4.70%) and it stands at
3,326,000. In seasonally adjusted terms, the quarterly variation is -2.29%. In recent months unemployment has decreased by 405,800 people (-10.87%).  The unemployment rate stands at 14.55%, which is 73 hundredths less than in the previous quarter. In the last year this rate has fallen by 1.83 points.

But whilst the news is indeed better we get some perspective by the fact that the unemployment rate at 14.55% is not only still in double-digits but is well over that Euro area average. Indeed it is more than 10% higher than in the UK or US and around 12% higher than Japan.

As to the youth employment situation the good news is that the number of 16-19 year olds employed rose by nearly 12% to 165.500 over the past year. However some 137,800 are recorded as unemployed.

Comment

The Spanish economy has provided plenty of good news for the Euro area in the past few years, but that does not mean that there are no concerns. We have already looked at the issue of house prices and the past fears which arise from their development. Also for those who consider this to be because of the “internal competitiveness” model will be worried by this described by El Pais.

External demand, which helped in the worst moments to pull the Spanish economy, subtracted 0.5 points per year from GDP. And in the quarter, exports fell by 1.8%, entering for the first time negative rates since the third quarter of 2013. While it is true that imports also decreased by 1.2%.

Some of this no doubt relates to the automotive sector which for those who have not followed developments has been a success for Spain albeit that some of the gains have come from cannibalising production from elsewhere in the Euro area. An example of a troubled 2018 has been provided by Ecomotor today by revealing that VW Navarra has cut its production target by 10,000 cars for 2018. Oh and I nearly forgot to mention the Spanish banks especially the smaller ones hit by the court ruling on Stamp Duty.

But returning to the good news the economic growth means that Spain has seen the debt to GDP ratio that had nudged above 100% drop back to 98.3%. That is the road to a ten-year bond yield less than half that of Italy at 1.56% in spite of the fact that the planned fiscal deficit at 2.7% is higher.

The Euro area GDP slow down puts the ECB in a pickle

Some days several economic themes come at us at once and this morning is an example of that. Only yesterday I was pointing out the problems of establishment Ivory Tower economic forecasting via the continued failures of the Office for Budget Responsibility or OBR. For many in the media it was a case of carry on regardless in spite of the fact that it was a Budget essentially based on past OBR errors. Perhaps they did not realise as they gave credibility to the GDP forecasts that they were based on the new establishment Ivory Tower theory that the economy cannot grow at an annual rate of more than 1.5%. A few decimal points were added and taken away at random to give a veneer of ch-ch-changes but that is the basis of it. Let me give you an example of this sort of Ivory Tower thinking from the OBR Report yesterday and the emphasis is mine.

In March 2017 and then again in November 2017, we reduced our estimate of the equilibrium rate of unemployment, in both cases reflecting the fact that unemployment had fallen below our previous estimate with little apparent impact on wage growth.

Actually those who recall the Bank of England using its Forward Guidance, which of course turned out to be anything but, pointing us towards a 7% unemployment rate will understand the intellectual bankruptcy of all this. But on this “output gap” rubbish goes mostly unchallenged.

Also what is not explained is why the future is so dim after so many extraordinary monetary policies that we keep being told were to boost growth.

The Italian Job

Those themes come to mind as yet another one has been demonstrated yet again by Italy this morning. From its statistics office.

In the third quarter of 2018 the seasonally and calendar adjusted, chained volume estimate of Gross Domestic Product (GDP) was unchanged with respect to the previous quarter and increased by 0.8 per cent over the same quarter of previous year.

This brings us back sadly to the “Girlfriend in a coma theme” where Italy cannot grow at more than 1% per annum on any sustained basis.

The carry-over annual GDP growth for 2018 is equal to 1.0%.

There was even a sort of a back to the future element if you take a look at the breakdown.

The quarter on quarter change is the result of an increase of value added in agriculture, forestry and
fishing and in services and a decrease in industry. From the demand side, there is a null contribution by
both the domestic component (gross of change in inventories) and the net export component.

If we now switch to forecasting it was only last Thursday lunchtime that Mario Draghi told us this at the ECB press conference.

Incoming information, while somewhat weaker than expected, remains overall consistent with an ongoing broad-based expansion of the euro area economy and gradually rising inflation pressures. The underlying strength of the economy continues to support our confidence that the sustained convergence of inflation to our aim will proceed……remains overall consistent with our baseline scenario of an ongoing broad-based economic expansion, supported by domestic demand and continued improvements in the labour market.

Just like in the song New York, New York it was apparently so good he told us twice. As to looking at Italy specifically we got a sort of official denial.

On Italy, you have to remember that Italy is a fiscal discussion, so there wasn’t much discussion about Italy.

An interesting reply as we note that no doubt they did have an estimate of the number and without the third-largest economy can you call an expansion broad-based? Actually the latest Eurostat release challenges that statement much more generally.

Seasonally adjusted GDP rose by 0.2% in the euro area (EA19) and by 0.3% in the EU28 during the third quarter
of 2018…. In the second quarter of 2018, GDP had grown by 0.4% in the euro area and by 0.5% the EU28. Compared with the same quarter of the previous year, seasonally adjusted GDP rose by 1.7% in the euro area and
by 1.9% in the EU28 in the third quarter of 2018, after +2.2% and +2.1% respectively in the previous quarter.

As you can see the annual economic growth rate in the Euro area has been falling throughout 2018 as we recall that in the last quarter of 2017 it was 2.7% as opposed to the current 1.7%. This poses a question for a central bank doing this.

Regarding non-standard monetary policy measures, we will continue to make net purchases under the asset purchase programme (APP) at the new monthly pace of €15 billion until the end of December 2018. We anticipate that, subject to incoming data confirming our medium-term inflation outlook, we will then end net purchases.

The simple fact is that if we allow for monetary lags then the reduction in monthly asset purchases from the peak of 80 billion Euros a month has been followed by a fall in economic growth. If we switch to the quarterly numbers we see a fall from 0.7% to 0.2% and there must be further worries for the last quarter of 2018.

Eurozone GDP growth continues to ease in line with PMI data, according to initial Q3 estimate. Flash October data signals further loss of momentum at the start of Q4. ( Markit PMI)

Back to Italy

Returning to an Italian theme there are genuine concerns of further trouble combined with some perspective from @fwred on twitter.

Italian GDP misses: stagnation in Q3 (+0.02% QoQ) and still 5% below pre-crisis levels. Material risk of a ‘triple dip’. Economic reality comes at you fast.

Let us hope that Italy has the same luck with a “triple dip” that the UK had back in 2012. But the real perspective and indeed measure of this part of the Euro area crisis is the fact that the economy is still some 5% smaller than a decade ago. No wonder voters wanted change.

A catch comes if we switch back to looking at forecasts again as we note that the new government has veered between optimistic ( 1.5%) on economic growth and what Cypress Hill described as “Insane in the membrane” with 3%. Politicians like a 3% growth rate as for example it was used by both sides in the UK 2010 general election. Why? It makes their plans look affordable and if (when) it goes wrong they simply sing along with Temptation(s).

But it was Just my imagination,
once again runnin’ away with me.
It was just my imagination runnin’ away with me.

If it goes really badly then they deploy Lily Allen.

It’s Not Me, It’s You

Meanwhile the tweet below describes the consequences.

Comment

There is a lot to consider here so let me start with the ECB. It now staring down a future like the one I have feared and written about for some time where the Euro area economy behaves in a junkie economics manner. Once the honey is withdrawn so is the growth. As ever that is not the only factor in play as economics does not have any test tubes but governing council members must be thinking this as they close their eyes at night. Well the brighter ones anyway.

What does it do then? It may still end monthly QE but that is mostly because it has been running out of German bonds to buy. My view that Mario Draghi intends to leave without ever raising interest-rates gets another tick. Maybe we will see the so far mythical OMTs or Outright Monetary Transactions deployed and Italy would be an obvious test case.

Also let me offer you one more morsel as food for thought. We keep being told about the OBR and ECB being “independent”. Have you spotted how “independent” bodies so regularly do the will of the establishment and sometimes manage to do more than the establishment itself could get away with?

 

 

What if Italy slips back into an economic recession?

A feature of bond market and debt crises is not only how far the market falls but how long it lasts. This is because as the majority and sometimes vast majority of debt issued has a coupon ( interest) fixed for its term and so fluctuations in the meantime do not matter for them. The catch is that new deficits need to be financed and existing debt needs to be rolled over and it does matter for them. An example of that is provided by Italy which will issue 2 billion Euros of 5 year bond and 2.5 billion of a ten-year one next week and these will be much more expensive than would have been predicted not so long ago. According to the Italian Treasury or Tesoro some 200 billion Euros of maturities are due next year if we ignored the rolling over of Treasury Bills.

Thus you can see how it takes a while for the costs of a bond market decline to build but build they do. The exact amount varies as for example last Friday we were looking at the nadir for the market so far with a ten-year yield of 3.8% and as I type this it is 3.5%, but both spell trouble. We see regular examples of why this may be bad but let us move to an area where contagion is possible.

The Italian banking system holds €350 billion of government bonds. If 10-year government-bond yields hit 4%, banks’ equity capital will just about equal their nonperforming loans. ( Felix Zulauf in Barrons)

Did anybody mention the Italian banks?

You may not be surprised to read that the ECB press conference yesterday was pretty much a Q&A session on Italy and during it President Draghi told us this.

However we have now the bank lending survey of this quarter. It does say that basically, terms and conditions applied by Italian banks on new loans to enterprises and households for house purchases, tightened. Terms and conditions – so not standards – terms and conditions tightened in the third quarter of 2018, driven by a higher cost of funds and balance sheet constraints.

So things have got tighter for the Italian banks and they have passed it the higher costs to both personal and corporate borrowers. The subject did not go away.

On Italy, I don’t have a crystal ball; I don’t have any idea whether it’s 300 or 400 or whatever. So it’s difficult. But certainly these bonds are in the banks’ portfolios. If they lose value, they are denting into the capital position of the banks; that’s obvious, so that’s what it is.

This was in response to a (poor) question about at what level of the yield spread would the Italian banks hit trouble and the suggestion it might be 400? A better question would be based on Italian yields alone. Also central bankers are hardly likely to tell you a banking crisis is in its way! But you may note that Mario mentioned 3% as opposed to 4% to perhaps cover himself. Also as a former Governor of the Bank of Italy and the Draghi in the Draghi Laws which cover Italian banking his “crystal ball” should be one of the best around.

This brings me to the issue of the Atlante Fund where Italian banks essentially bailed out other Italian banks. We do not seem to get any updates on it now. Can anybody think what might be happening to a portfolio of non-performing Italian bank loans right now? I recall being told that the deals to take such loans were really good value and that my fears were over done. Now I note that the same Unicredit that I called a Zombie bank around 7 years ago on Sky News looks rather like a Zombie bank to me if you look at all the cash piled in since then and the current share price. This whole issue has been a banking crisis in slow motion so let me remind you of the latter parts of my timeline for a banking collapse.

9. Debt costs of the relevant sovereign nation or nations rise.

10. Consequently that nation finds that its credit rating is downgraded.

11. It is announced that due to difficult financial times public spending needs to be trimmed and taxes such as Value Added Tax need to be raised. It is also announced that nobody could possibly have forseen this and that nobody is to blame apart from some irresponsible rumour mongers who are the equivalent of terrorists. A new law is mooted to help stop such financial terrorism from ever happening again.

12. Some members of the press inform us that bank directors were both “able and skilled” and that none of the blame can possibly be put down to them as they get a new highly paid job elsewhere.

13. Former bank directors often leave the new job due to “unforseen difficulties”.

The Budget Plan

If we move on from the “doom loop” that exists between the Italian economy and its banks we get the current fiscal plan which is to run a deficit of 2.4% of GDP ( Gross Domestic Product). Some number-crunching has been undertaken on this by Olivier Blanchard at the Peterson Institute with some intriguing results.

So, take 0.8 percent of GDP to be the relevant measure of expansion………..To give the government the benefit of the doubt, take a multiplier of 1.5. Then, one would expect an increase in output of 1.5 * 0.8 = 1.2 percent on account of the fiscal stimulus.

So we are in the world, or at least what is left of it, of economics 101 where the extra fiscal stimulus will increase GDP by 1.2%. However there is a catch.

Turn to the other half of the story, the increase in interest rates. Since mid-April, Italian bond yields have risen by about 160 basis points……….Recent estimates of the effects of the OMT suggest slightly lower numbers for Italy, in the region of a 0.8 percent output contraction for a 100-basis-point increase in bond rates.

Some of you may have already completed the mathematical implication of this.

Putting fiscal multiplier effects and contractionary interest rate effects together—and being generous about the size of the multiplier and conservative about the effect of the interest rate increase—arithmetic suggests that the total effect on growth will be 0.8 * 1.5 – 0.8 * 1.6 ≈ –0.1. While this number comes with a large uncertainty band, the risks are skewed to the downside.

So via his methodology up is the new down. Or more formally the fiscal expansion seems set to weaken and not boost GDP.

One cautionary note is Olivier’s own record in this area as he was Chief Economist at the IMF when it was involved in the disastrous fiscal experiment in Greece which he sweeps up in this paper as “many politicians and economists argued”. This is of course one of the longest running feature of the credit crunch era as encapsulated by point 12 of my banking crisis time line above.

Comment

The issues above are brought into sharper focus if we note this Mario Draghi and the ECB yesterday.

while somewhat weaker than expected

That rather contradicted the by now usual “broad-based expansion” line which was backed up by some misleading analysis of the monetary situation. The minor swerve was the claim that M3 growth had risen by 0.1% which is true but only because August had been revised lower. The more major omission was the absence of a reference to it being 5.1% last September,

So if we add the expected slow down to the already troubled Italian situation we get a clearer idea of the scale of the problem. If we look back we see that GDP growth has been on a quarterly basis 0.3% and then 0.2% so far this year and the Monthly Economic Report tells us this.

The leading indicator is going down slightly suggesting a moderate pace for the next months.

They mean moderate for Italy.So we could easily see 0% growth or even a contraction looking ahead as opposed some of the latest rhetoric suggesting 3%  per year is possible. Perhaps they meant in the next decade as you see that would be an improvement.

 

 

What next for the War on Cash?

Yesterday we took a look at a country which seems to be happy heading for a post cash era. Sweden has seen nearly a halving of cash use in the past decade and the size of the change would be even larger if we factored in inflation and did the calculation in real terms. This is particularly significant as we remind ourselves that Sweden already has negative interest-rates, and as I pointed out yesterday there are roads ahead where it would cut them further from the current -0.5%. The reason why cash is an issue for negative interest-rates is that it offers 0%, and so there must be a “tipping point” where interest-rates go so negative that bank deposits switch to cash in enough size to create a bank run. Such a prospect has created terror in central banking halls and boardrooms and has been the main barrier to interest-rates being cut even lower than they have. In my own country the Bank of England was so terrified of the impact of lower interest-rates on the “precious” that it claimed 0.5% was a “lower bound”, even when other countries were below it. That had a different reason ( their creaking antiquated IT systems could not cope with 0%) but told us of their primary response function.

Cash in the USA

The Financial Times has taken a look at this and seems upset at the result.

Americans can’t quit cash

If we switch to the actual research which was undertaken by  the Federal Reserve Banks of Atlanta, Boston, Richmond, and San Francisco we see the following.

In October 2017, U.S. consumers each made on average 41.0 payments for the month . Thus, on average, an adult consumer made 1.3 payments per day. Notably, an average
of 40.2 percent of consumers per day reported making zero payments. Also in October 2017, U.S. consumers each made on average $3,418 worth of payments for
the month.

So after finding out how much as well as how often? We get to see via what method.

In October 2017, consumers paid mostly with cash (30.3 percent of payments), debit cards (26.2 percent), and credit cards (21.0 percent). These instruments accounted for three-quarters of the number of payments, but only about 40 percent of the total value of payments, because they tend to be used more for smaller-value payments. In contrast,
electronic payments accounted for 30.3 percent of the value of total payments but only 8.9 percent of the number
of payments. Checks, at 17.7 percent, continued to account for a relatively high percentage of the value of
payments.

As you can see cash remains king (queen) in volume terms but has faded in value terms. The bit that sticks out to me is the amount still accounted for by Checks ( cheques) as I am struggling to think of the last time that I used one. Also the comments section provides a reason as to why cash remains in use for small payments on such a large-scale in the US.

Americans carry cash for smaller transactions partly because their unstinting devotion to the $1 bill means it is much lighter.  I can carry round a bunch of 1s and 5s for coffee in the day at a fraction of the weight of the euros or pounds that would do the similar job in Europe. ( Saughton)

For those unaware UK coins are fairly heavy and the £1 and £2 coins get more use than you might expect as the Bank of England has had its struggles with getting £5 notes into general circulation. So suit and trouser pockets can take a bit of a pasting. If we continue in the same vein even the convenience of digital payments faces an apparent challenge.

Those of us still paying cash are standing in lines behind phonsters fumbling with their payment app. When it looks faster and easier I’ll switch. ( Proclone )

That may be because it does not work well.

The other main reason the US lags on electronic purchases is because the cashless infrastructure is atrocious. ( Saughton)

Also that it may be businesses rather than consumers which prefer cash.

Mom and pop stores and restaurants may require cash for any transaction, and almost all do for purchases under $10. Cheques for larger payments are also due to vendor requirement. That dynamic would be worth comparing to other markets instead of implying consumer preference. ( Pharmacy )

What about the Euro area?

I noted that the replies pointed out the way that cash remains prevalent in Germany (historical), Belgium ( tax-avoidance) and Austria ( see Germany) so let us take a look. From the European Central Bank or ECB.

The survey results show that in 2016 cash was the dominant payment instrument at POS. In terms of number, 79% of all transactions were carried out using cash,
amounting to 54% of the total value of all payments. Cards were the second most frequently used payment instrument at POS; 19% of all transactions were settled using a payment card. In terms of value, this amounts to 39% of the total value paid at POS. ( POS = Point Of Sale )

I doubt using geography as a method of analysis will surprise you much.

In terms of number of transactions, cash was most used in the southern euro area countries, as well as in Germany, Austria and Slovenia, where 80% or more of POS transactions were conducted with cash……… In
terms of value, the share of cash was highest in Greece, Cyprus and Malta (above 70%), while it was lowest in the Benelux countries, Estonia, France and Finland (at,
or below, 33%).

The ECB thinks it tells us this.

This seems to challenge the perception that
cash is rapidly being replaced by cashless means of payment.

It then goes further.

The study confirms that cash is not only used as a means of payment, but also as a store of value, with almost a quarter of consumers keeping some cash at home as a
precautionary reserve. It also shows that more people than often thought use high denomination banknotes; almost 20% of respondents reported having a €200 or
€500 banknote in their possession in the year before the survey was carried out.

This means that the ECB will find itself in opposition to more than a few of its population soon.

 It has decided to permanently stop producing the €500 banknote and to exclude it from the Europa series, taking into account concerns that this banknote could facilitate illicit activities. The issuance of the €500 will be stopped around the end of 2018, when the €100 and €200 banknotes of the Europa series are planned to be introduced,

 

Comment

Let us consider the relationship between the use of cash and financial crime. You may note that the ECB statement uses the word “could”. That as I pointed out back on the 5th of May 2016 is because the German Bundesbank thinks this.

There is scant concrete information on the extent to which cash is being used to facilitate illicit activity……… the volume of notes devoted to such transactions is unknown and would be extremely difficult, if not impossible, to estimate.

So the ECB seems to be basing its policy on the rhetoric of Kenneth Rogoff who in a not entirely unrelated coincidence thinks that central banks will have to go even further into negative interest-rates next time around. Our Ken has been rather quite recently on the subject of cash equals crime. This may be because if we look above we see that Estonia has moved away from cash both relatively and absolutely and yet you will have had to have spent 2018 under a stone to have missed this.

Danske Bank Estonia has been revealed as the hub of a $234bn money laundering scheme involving Russian and Eastern European customers. ( Frances Coppola)

Perhaps the authorities were too busy checking on the 500 Euro notes and missed a crime that would have taken four of out five of the total Euro area circulation. Priorities eh?

There are levels I think where this will be come more urgent. I have suggested before that I think that around -2% would be the level where people might move away from banks on a larger scale. So far in terms of headline official rates the lowest is the -0.75% of Switzerland. Of course another problem area would be created if we saw bank bailins on any scale which may be a reason why so many bank share prices have struggled.

Me on Core Finance TV

 

 

 

How easily could the promises of an interest-rate rise from the Riksbank turn into another cut?

Today brings us to the country which on one measure has dipped into the world of negative interest-rates more than anyone else. This is the world of the Riksbank of Sweden which has this interest-rate on deposits with it.

The standing deposit facility means that the counterparty may have a positive balance on its account in RIX at the end of the day. The counterparty then receives interest calculated as the repo rate minus 0.75 percentage points. If this entails a negative interest rate, the counterparty pays interest to the Riksbank.

This is because the headline Repo rate is -0.5% meaning that the standing deposit facility is currently -1.25%.

For some time now, partly because as we will come to in a minute negative interest-rates have proved to be much longer lasting than promised or in official language been temporary, we have looked at the impact of this in cash and its availability. That has been in the news this week.

As cash use is declining rapidly, it is important that the Riksdag adopt a position on the issue of what constitutes legal tender in Sweden and its connection to the Swedish krona as a currency. Any legislation should be as technology-neutral as possible in order to also be applicable to any future means of payment issued by the Riksbank. ( Riksbank)

Sweden is a country which is in the van of those using electronic means of payment and if we look at the official figures the amount of money ( notes & coins) in circulation has been falling, at times sharply. The amount was 88 billion Kronor in 2013 and in subsequent years then has gone 80 billion, 77 billion, 65 billion and then 57 billion. The trend gets even clearer if we look back to 2008 the table suggests that the amount was around 107 billion. So we are left wondering if this year the amount will be half what it was in 2008.

However you spin it the situation is such that cash needs protection according to the Riksbank.

The Committee proposes a requirement that companies shall be able to deposit their daily cash takings in their bank accounts. The Riksbank wishes to go a step further even in this regard. Banks should also be obliged to ensure that private individuals can make deposits.

Of course some will think to quote Hamlet “”The lady doth protest too much, methinks”

The State of Play

According to the Riksbank things are going really rather well.

Economic activity in Sweden is strong and inflation is at the target of 2 per cent. Since the monetary policy decision in September, developments have for the most
part been as expected and the forecasts remain largely unchanged.

It hammers home the point even more later.

In Sweden, too, economic developments have been largely as expected and economic activity has been good for a long period of time……….. Inflation increased to
2.5 per cent in September, partly as a result of rapidly rising energy prices. Different measures of underlying inflation are lower and inflationary pressures are still assessed to be moderate. However, there are signs that inflationary pressures are rising and the conditions are good for inflation to remain close to the target of 2 per cent in the coming years.

I have given the full detail on the inflation situation because it highlights the mess that the Riksbank has put itself in. Inflation has gone above target and like so many central banks it is then keen to find any measure which gives a different but then trips over its own feet by telling us “inflationary pressures are rising”. So we have a tick in the box for an interest-rate rise.

Let us now look at the economic performance.

The labour market situation is expected to remain strong, even if GDP growth slows down going forward.

This is based on this from Sweden Statistics.

Sweden’s GDP increased by 0.8 percent in the second quarter of 2018, seasonally adjusted and compared with the first quarter of 2018. GDP increased by 2.5 percent, working-day adjusted and compared to the second quarter of 2017.

If we look back we see that GDP growth was 2.6% in 2014 then 4.5% in 2015 and then 2.7% in 2016. So the position has been strong for a while although the per capita (person) situation is not as strong as the population has risen by 2.3% over the same period.

Monetary Policy

If we note that the economy has been doing well and inflation is above target you would not expect this.

 the Executive Board has decided to hold the repo rate unchanged at -0.50 per cent.

There are two issues here the first is how it has arrived at a strong economy and inflation above target with interest-rates negative and the next is how doing something about this remains just around the corner.

the Executive Board assesses that it will soon be appropriate to start raising the repo rate at a slow pace. The forecast for the repo rate is unchanged since the monetary policy meeting in September and indicates that the repo rate will be raised by 0.25 percentage points either in December or February.

As an aside it used to be the case that central banks used to think that what is now called Forward Guidance was a bad idea. The Bundesbank of Germany was particularly enthusiastic about trying to act in an unexpected fashion. There is however a catch.

As you can see it has a 0% success rate with its interest-rate forecasts so whilst in theory it has a policy opposite to that of the Bundesbank in practice it has turned out to have even more surprises. Well unless you possess enough brains to figure out the game. Even more than the Bank of England it has attempted to get the changes provided by an interest-rate rise from promising it rather than delivering it. If there is a clearer case of the central banking boy (girl) who cried wold I do not know it.

Money Supply

You may not be surprised to read that money supply growth soared in response to  the negative interest-rates and QE of the Riksbank. In fact narrow money growth rate 15% at the opening of 2016 and broad money just failed to make double digit growth as it peaked at 9.9%. You might think if you look at the GDP growth data for the year that it was time to raise interest-rates but like the Bank of England when it had the chance the Riksbank apparently knew better.

Now we find something awkward for the recycled promise of an interest-rate rise. This is that in 2018 narrow money growth has fallen from 8.4% to 6.8% and broad money growth has fallen from 5.4% to 4.5% and as the 5.4% was a freak number if you look at the series as we had 6.4% through the spring. So looking at them in isolation you might be thinking of an easing. Oh hang on…..

Comment

The Riksbank changed course around 5 years ago and since then has mostly run a pro-cyclical monetary policy and reversed the conventional view on how to operate it. Regular readers will recall that was partly driven by Paul Krugman calling them “sado-monetarists” and they may also note that mentions of Mr. Krugman have noticeably faded. But they will also be aware that I have argued that negative interest-rates were described pretty accurately by Elvis Presley.

We’re caught in a trap
I can’t walk out
Because I love you too much, baby

But as even supporters of the guidance are suggesting that there may only be one interest-rate rise I see trouble ahead. Monetary growth is plainly slowing and this week has brought news that such slowing in the Euro area is having an effect. The Bundesbank is worried about economic growth in Germany and this morning’s Markit business survey told us this.

The pace of Eurozone economic growth slipped
markedly lower in October, with the PMI setting the
scene for a disappointing end to the year.

So whilst two members of the Riksbank did vote for an interest-rate increase today I can see two scenarios increasing in probability. One is that they eventually do raise but then reverse quite quickly. Or more darkly that the next move is either another cut or easing in another form such as QE which would be the final confession that they are in as Coldplay put it.

And I lost my head
And thought of all the stupid things I said
Oh no what’s this
A spider web and I’m caught in the middle