The issue of monetary policy in the Euro area is of significance on several levels. Obviously it affects the Euro area itself but also it affects many countries around it as in a nod to the sad departure of Stephen Hawking overnight it is time to sing along with Muse.
Into the supermassive
Supermassive black hole
Supermassive black hole
Supermassive black hole
Supermassive black hole
This has been demonstrated by the way that zero and then negative interest-rates ( a deposit rate of -0.4%) in the Euro has forced others in the locale to follow suit. It was and is a factor in the -0.5% of Sweden the -0.65% certificate of deposit rate in Denmark and the -0.75% of Switzerland amongst others. It is also a factor in the UK still remaining with a Bank Rate of 0.5% after so many years have passed and not following the more traditional route of aping the moves of the US Federal Reserve.
This is the question on many lips both inside for obvious reasons but also outside the Euro area for the reasons above. Why? Well the President of the European Central Bank Mario Draghi explained this earlier today in Frankfurt.
The economy has been growing consistently above current estimates of potential growth, by more than a percentage point last year. All euro area confidence indicators are close to their highest levels since the start of monetary union, even if the latest readings came in slightly below expectations.
This as I regularly point out means that monetary policy is facing a new frontier. This is because it is procyclical where it is expansionary in an existing expansion. Mario has in fact gone further than me in one area as in his view it is even more procyclical leading to output being more than 1% above potential. If that sounds a little mad I will return to it in a moment. But another factor in this new frontier is the way that both negative interest-rates and QE have been deployed.
We’ll open up the doors and climb into the dawn
Confess your passion your secret fear
Prepare to meet the challenge of the new frontier ( Donald Fagen)
Looking at what output has been allows us to figure it out.
Over the whole year 2017, GDP rose by 2.3% in the euro area ( Eurostat)
That would mean that potential output is only 1% per annum but I suspect Mario really means the 2.7% if you compare the last quarter of 2017 with a year before so 1.5%. That is rather downbeat which is very common amongst central bankers these days as for example Governor Carney and the Bank of England used different language “speed limit” for the UK but also came to 1.5%. Due to demographic pressures the Bank of Japan is even more downbeat for Nihon at 1%.
We will see how the media treat that as they make a big deal of the UK situation but let is move onto what causes them to think this? We come to something which is genuinely troubling.
Second, the degree of slack itself is uncertain. Even if slack is now receding, estimates of the size of the output gap have to be made with caution. Strong growth may be leading to higher potential output, as crisis-induced hysteresis may be reversed in conditions of stronger demand. And the effects of past structural reforms, especially in the labour market, may now be showing up in potential output.
As you can see the certainty of earlier has gone as this clearly points out they do not know. We are back to imposing theory on reality again and even worse a failed theory as later we get this.
Phillips curve decompositions find that past low inflation dragged down wage growth from its long-term average by around 0.2 percentage points each year between 2014 and 2017.
If we step back we see that according to the Phillips Curve wages should be soaring as we are above potential output whereas in fact they are doing this.
The unexplained residuals in the model – which in the past were sizeable – are diminishing, suggesting the link between unemployment and wages should improve.
As in there is no link visible yet but if you inhale enough hopium it will be along at some point! Also I hope you enjoyed the reference to labour market reforms from Mario as we mull the contrast between that and his policy press conferences which every time without fail have a section calling for economic reform.
More! More! More!
It is somewhat awkward when you are telling people the economy is running hot and implying it is overheating if you also say it may be about to run faster.
Non-essential purchases – which make up around 50% of household spending in the euro area – tend to be postponed during recessions and then to catch up as the business cycle advances. Such purchases are currently only 2% above their pre-crisis level, compared with 9% for essential ones. This implies that discretionary household spending still has scope to support the expansion.
So it is below potential Mario? Also an area central bankers love to see boom also seems to be below potential.
Moreover, housing investment is still 17% below its pre-crisis level and is only now starting to pick up, which will likely add an extra impulse to the recovery dynamic.
What about inflation?
This if you look at a Phillips Curve world should be on the march in both senses as wages and prices should be heading upwards and yet.
Wage growth has been trending upwards for the euro area as a whole, rising by 0.5 percentage points from the trough in mid-2016.
Not much is it? As to be fair Mario points out.
But consistent with the weakening of the relationship between slack and inflation, the adjustment of wages during the recovery has so far been atypically slow.
The trouble is the analysis seems to be based on pure hopium.
That said, our analysis suggests that, as the cycle advances, the standard wage Phillips curve should hold better for the euro area on average. The unexplained residuals in the model – which in the past were sizeable – are diminishing, suggesting the link between unemployment and wages should improve.
So when you really want it to work ( in a crisis) it fails and in calmer times it does not seem to work either. But they will continue with it anyway like someone who s stuck in the mud.
Actually I think that Mario Draghi is more intelligent than this as we see several themes come together. Back in the dim and distant days when I began Notayesmanseconomics I offered the opinion that central bankers would dither when it became time to reverse course on their stimuli. This became a bigger factor as the stimuli grew. Now we see a central banker telling us.
But we still need to see further evidence that inflation dynamics are moving in the right direction. So monetary policy will remain patient, persistent and prudent.
This works nicely for Mario as the inflation forecasts remain below the 1.97% inflation target defined by a predecessor of his ( Monsieur JC Trichet).
The latest ECB projections foresee a pickup in headline inflation from an average rate of 1.4% this year to 1.7% in 2020.
Thus as he has hinted at in past speeches which more than a few seem to have forgotten Mario Draghi may depart as ECB President without ever raising interest-rates. In fact it seems to be his plan and it is something he will leave as a “present” for whoever follows him. Another form of stimulus may have slowed but is still around as well.
The cumulative redemptions under the asset purchase programme between March 2018 and February 2019 are expected to be around EUR 167 billion. And reinvestment amounts will remain sizeable thereafter.
So now we see that policy has been decided and a theory ( Phillips Curve ) has been chosen which is convenient. Mario may not believe it either but it suits his purpose as does claiming their has been labour market reform. This is the same way that we have switched from the economic growth of the “Whatever it takes” speech to inflation now both suggest the same policy which allows Mario to give himself a round of applause.
Considering all of the monetary measures taken between mid-2014 and October 2017, the overall impact on euro area growth and inflation is estimated, in both cases, to be around 1.9 percentage points cumulatively for the period between 2016 and 2019.
So another masterly performance from Mario Draghi but it should not cover up the many risks from advancing onto a new frontier of procyclical monetary policy.