Should the ECB be reformed and how?

This morning has brought an intriguing opinion piece in the Alphaville section of the Financial Times. It concerns the European Central Bank and comes from what you might call a classic insider as the header suggests.

Lorenzo Bini Smaghi, Société Générale chairman, Project Associate at the Harvard Kennedy School’s Belfer Center for Science and International Affairs, and Senior Fellow at LUISS School of European Political Economy in Rome.

This covers a lot of ground as after all shouldn’t  being chairman of Societe Generale be a full-time job? This dichotomy where lower jobs are full-time but more senior ones are not seems to be ever more common. With a share price less than a quarter of what it was at its peak and furthermore it being down 25% over the past year you might think directors would be fully employed trying to make things better. Of course we are invariably told that such people can have so many roles because they are so capable and intelligent which of course then begs the question of how we are where we are?

For some reason the Financial Times header was a little forgetful of the fact that Mr Bini Smaghi was an Executive Board member of the ECB for six years from 2005. This matters as it is likely that he is being used like a weather vane, so let us take a look.

The Inflation Target

Here is the opening salvo, with which regular readers will be familiar.

The ECB’s primary objective is price stability, defined as “a rate of inflation below but close to 2 per cent”. The average inflation rate over the 20 years of the euro has been 1.7 per cent, which may suggest success.

Now even your average Martian will be aware that the last decade has not been a success but look what Lorenzo picks out.

However, the result has been less satisfactory (a dalliance with deflation) in more recent periods.

This focusing on deflation is misleading for several reasons. Firstly he is deliberately equating falling prices or disinflation with shrinking aggregate demand or deflation. This matters because Lorenzo’s “deflation” was essentially the result of a lower oil price as I pointed out at the time. Also rather than a problem, at a time of restricted wage growth lower and indeed negative inflation provides an economic boost via its positive impact on real wages. I pointed this out back on the 29th of January 2015.

However if we look at the retail-sectors in the UK,Spain and Ireland we see that price falls are so far being accompanied by volume gains and as it happens by strong volume gains. This could not contradict conventional economic theory much more clearly.

Thus Lorenzo is flying something of a false flag here and is an example of what I predicted back then.

 If the history of the credit crunch is any guide many will try to ignore reality and instead cling to their prized and pet theories but I prefer reality ever time.

You will not be surprised to find that the suggestion is a loosening of the target as seen below.

 Furthermore, research shows that the ECB’s policy decisions over the years anyway reflect a symmetric interpretation of the target around 2 per cent. So why not move to such a target? It would at least be more transparent.

This matters even more if we note that in spite of the negative interest-rates and the QE inspired balance sheet expansion the ECB has in its own terms not yet achieved its target. This is because whilst inflation is above 2% at 2.1% of that some 0.8% is energy costs which are mostly outside its control. Putting it another way it is remarkable how little consumer inflation has been created by so much monetary easing. In fact with it so low we have to question whether it also has disinflationary influences not predicted by economics 101.

Thus even what seems a minor reshuffling of the target would if we remain in a similar situation to now lead to the possibility of a large policy change. We could get QE to its current maximum in terms of Euro area sovereign bonds where they are bought up to the limit imposed by the German bond market. In a way it all comes from this misrepresentation or lie.

 reconsider the definition of price stability.

Price stability would be 0% not 2% per annum. In response my suggestion would be to lower the Euro area inflation target to either 1.5% or 1%.

Signals

The next bit is even odder.

The two pillars are analysis of economic and monetary data, but the latter — money and credit aggregates — have proved over time to be unreliable predictors of inflationary pressures……….. In July 2008, for instance, the resilient fast pace of credit growth justified the rate hike which was made, even as the real economy had started to show signs of a slowdown

Actually if we look at annual M1 growth which is the leading indicator for monetary data the annual rate of growth had fallen from 11.7% in December 2005 to 0.1% in July 2008. So the truth is that the ECB simply looked at (backwards-looking) credit growth rather than the clear signal from M1. Actually, looking at like that the series without seasonal adjustment could hardly be much clearer.

Collateral

As you can imagine our bank chairman is not keen on the way countries can be excluded from this. After all who will think of the banks holding their debt? Here is his proposed solution.

Consideration should be given to return to a system based on progressive haircuts.

Share risk, as well as supervision

This would have the Starship Enterprise on yellow if not red alert. This is the current state of play.

Banks that are solvent, but do not have adequate collateral, may require the central bank to act as a so-called “lender of last resort”. That function for banks is still decentralized, with the national central banks bearing the risks.

So if an Italian bank were to fail it is the responsibility of the Bank of Italy to step in. Whereas Lorenzo wants this.

In particular, if the decision on whether a bank is solvent and is eligible to emergency lending is centralized, the risk for such lending should be shared.

So in this new universe the ECB would be responsible and not the Bank of Italy as the federal web gets more steel and perhaps titanium. The issue of being “solvent” is usually a red herring as central banks seem to find the most disastrous business models as being viable.

Exit Troika, stage left

Nobody seems to have told Lorenzo about the nomenclature change to “The Institutions”, but of course bankers often struggle with current events. Anyway it is hard to disagree with the thrust here, frankly who would want to be a member of it?

Remaining a member of the Troika is now less justified, and the unpopularity of adjustment programmes tends to erode the ECB’s reputation and independence.

Let somebody else take the blame!

Comment

The good news is the implied view that the ECB needs reform. Sadly the predictable part is that it heads in a direction which has so far caused more trouble than it has solved. For those who believe that the Euro establishment want crises so that they can present what they wanted to achieve anyway as part of the crisis resolution there is another tick in that box. My suggestion would be for a much more root and branch reform of central banking. For example inflation control has morphed into inflation creation or in consumer inflation terms attempted inflation control. Plus of course a boost for those who own assets.

However it is also true that the ECB has been left exposed and in the cold by the Euro establishment. The lack of any political response in terms of economic policy to the credit crunch left it and monetary policy with far too much to do. It has overplayed its hand in response, and must now fear heading into the next downturn with its foot still pressing down on the accelerator. At least it managed to shuffle its holdings of Greek debt largely to another Euro area body but that process and its insistence on full repayment added to the crisis at its height.

Heading forwards I would have two main suggestions.

  1. Lower the inflation target
  2. Much more questioning of what QE actually achieves.
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Sweden is a curious mixture of monetary expansionism and fiscal contraction

This morning has brought us a new adventure in the world of central bank Forward Guidance.

The Executive Board has therefore decided to hold the repo rate unchanged at −0.50 per cent. If the economy develops as expected, there will soon be scope to slowly reduce the support from monetary policy. The forecast for the repo rate indicates that it will also be held unchanged at the monetary policy meeting in October and then raised by 0.25 percentage points either in December or February.

You may already have realised that this is from the Riksbank of Sweden and that there is something awfully familiar about this as Martin Enlund highlights below.

There are a multitude of issues here. Let us start with the fact that the Riksbank was ahead of the game in offering Forward Guidance before the concept was formally devised. I guess that sits well with being the world’s oldest central bank. But the catch so typical of the way that Forward Guidance has developed is that it has proven spectacularly wrong! Indeed I cannot think of any central bank that has such a malfunctioning crystal ball. Ever since 2012 an interest-rate rise and indeed succession of rises has been just around the corner on a road that has been so straight even the Roman Empire would be proud of it.

One of the features of Forward Guidance is that it is supposed to allow businesses and households to plan with certainty. The reality here is that they have been consistently pointed in the wrong direction. Indeed their promises of interest-rate rises morphed into interest-rate cuts in the period from 2012 to 2016. Such that their forecasts if we try to average them, suggested the repo rate now would be of the order of 3-4%, rather than the actual -0.5%. If we look at the period when the repo rate has been negative they have consistently suggested it is temporary but it has been permanent so far, or if you prefer has been temporary as defined in my financial lexicon for these times.I think that there are two major possibilities here. The first is that they are collectively incapable of seeing beyond the end of their noses. The other is that it has been a deliberate policy to maintain negative interest-rates whilst promising to end them.

A more subtle suggestion might be that this is all for the foreign exchanges who do take a least some notice rather than the average Swede. After all if he or she did take notice of the Forward Guidance they have probably long since given up.

The Krona

We get the picture here from this from Bloomberg.

Sweden’s elections this weekend could spell more pain for an already floundering currency.

As ever I will skip past the politics and look at the currency. One cannot do so without first noting the role of the Euro here which is like a big brother or sister to its neighbouring nations. When it cut interest-rates it put pressure on them to cut as well. So let us look at the Krona versus the Euro.

What we see is a clear pattern. Essentially the monetary easing of the Riksbank has taken the Krona from 8.4 versus the Euro in the late summer of 2012 to 10.57 as I type this. So a gentle depreciation to add to the negative interest-rates in terms of monetary policy as we rack up the stimulus count.

We can take that wider by looking at the trade-weighted or Kix Index. If we do so we get a similar result as the 102 of late summer 2012 has been replaced by 121 now. Just for clarity this index operates in the reverse direction to the usual method as a higher number indicates a weaker currency.

If we switch to inflation prospects then some should be coming through as the Wall Street Journal reported yesterday.

Down 10% against the dollar, the krona has fallen more than any other developed-market currency. Among the 10 most heavily traded currencies in the world, it has undershot even China’s Yuan—itself under pressure from the trade conflict with the U.S.—and the U.K.’s Brexit-bruised pound.

So commodity prices will have risen in Krona terms from this effect.

QE

This has been another feature of the expansionary toolkit of the Riksbank

At the end of August, the Riksbank’s government bond
holdings amounted to just over SEK 330 billion, expressed as a  nominal amount .Net purchases of government
bonds will be concluded at the turn of the year, but principal  payments and coupon payments will be reinvested in the government bond portfolio until further notice.

So what has become regarded as a pretty regular QE programme which politicians love as it reduces borrowing costs for them. One generic point I would note is that these Operation Twist style reinvestments are only happening because QE has proven rather permanent rather than the extraordinary and temporary originally claimed. So far only the US Federal Reserve is attempting any unwind. Many argue this does not matter, but when you have redistributed both wealth and income towards the already wealthy I think that it does.

Money Supply

This has been an issue across more than a few countries recently, as we have been observing slow downs. This is also true of Sweden because if we look at the narrow measure or M1 we see that an annual rate of growth of 10.5% in July 2017 was replaced with 6.3% this July. If we look back we see that a major player in this has been the QE purchases because when the Riksbank charged into the bond market in 2015 the annual rate of growth in M1 went over 15% in the latter part of that year. Now we see as QE slows down so has M1 growth.

A similar but less volatile pattern can be seen from the broad money measure M3. That was growing at an annual rate of 8.3% in July 2015 as opposed to the 5.1% of this July. So we see clearly looking at these why the Riksbank has just balked on a promise to raise interest-rates at today’s meeting. Taken in isolation that is sensible and in fact much more sensible than the Bank of England for example which has just raised Bank Rate into monetary weakness.

House Prices

I would like to present this in a new way. We have a conventional opening as according to Sweden Statistics house prices fell by 1.2% in 2012 ( they measure one or two dwelling buildings) which explains the about turn in monetary policy seen then. But if we switch to narrow money growth we see that it looks like there is a link. It peaked in 2015 as did house price growth (10.8%). It remained strong in 2016 and 17 as did house price growth ( 8.4% and 8.3% respectively). Okay so with money supply growth fading what has happened to house prices more recently?

In the last three-month period, from June to August 2018, prices rose by almost 1 percent on an annual basis compared with the same period last year.

Boom to bust? As ever we need to be careful about exact links as for example the latest couple of months have been stronger. But what if monetary growth continues to slow?

Comment

Readers will be pleased to discover that the Riksbank has investigated its own policies and given itself a clean bill of health.

The Riksbank’s overall assessment is that the side‐effects
of a negative policy rate and government bond purchases
have so far been manageable.

Where there is a clear question is a policy involving negative interest-rates, QE and a currency depreciation when the economy is doing this.

Activity in the Swedish economy remains high. GDP growth in the second quarter was surprisingly rapid and together with strong indicators, this suggests that economic activity is still not slowing down.

Inflation is also on target. So why is policy so expansionary? Perhaps Fleetwood Mac are correct.

I never change
I never will
I’m so afraid the way I feel

Should they reverse course and find the economy and house prices heading south thoughts will be a lot harsher than the “Oh Well” of Fleetwood Mac.

Oddly we find that fiscal policy is operating in the opposite direction as this from the Swedish Debt Office shows.

For the twelve-month period up to the end of July 2018, central government payments resulted in a surplus of SEK 109.6 billion. Central government debt amounted to SEK 1,196 billion at the end of July. This corresponds to 2.3 and 25.3 percent, respectively, of GDP.

We are in a rare situation where they could genuinely argue they have a plan to pay it all off. The catch comes with the fact that with a ten-year bond yield of 0.54% and a low national debt they have no real need to. So a joined up policy would involve ending negative interest-rates and some fiscal expansionism wouldn’t it?

 

 

What can we expect next from the ECB?

Today the European Central Bank starts its latest policy meeting and tomorrow lunchtime we will be told the outcome. To my mind there are three certainties. The first is that ECB President Mario Draghi will call for more economic reforms in his introductory statement. The next is that he will wish everyone a happy holiday season at the end. The third is that he will find a way to point out that in its own terms the ECB has had a Eureka moment.From Eurostat.

Euro area annual inflation rate was 2.0% in June 2018, up from 1.9% in May 2018. A year earlier, the rate was
1.3%

So the 2% target has been hit and if you take the average of those 2 months you end up pretty near to the 1.97% specified back in the day in the valedictory speech of Mario’s predecessor Jean-Claude Trichet. Next comes this.

Seasonally adjusted GDP rose by 0.4% in the euro area (EA19) (and the EU28 during the first quarter of 2018),
compared with the previous quarter……..Compared with the same quarter of the previous year, seasonally adjusted GDP rose by 2.5% in the euro area.

So economic growth and inflation on target as Mario readies us for the last leg of his triple play.

The number of persons employed increased by 0.4% in both the euro area (EA19) and the EU28 in the first
quarter of 2018 compared with the previous quarter…….Compared with the same quarter of the previous year, employment increased by 1.4% in both the euro area and the EU28 in the first quarter of 2018……Eurostat estimates that, in the first quarter of 2018, 237.9 million men and women were employed in the EU28, of which 157.2 million were in the euro area. These are the highest levels ever recorded in both areas.

So as you can see even the perennial bugbear which is the employment situation in the Euro area has improved. This brings me to another certainty these days which is that Mario will run rings around the journalists at the press conference. The only danger to that is overconfidence as he sings along to Flo and her Machine.

The dog days are over
The dog days are done

A nagging problem

The catch to the scenario above is that the punch bowl at this particular party is still pretty full. No longer right up to the brim but there is still a -0.4% deposit rate and this.

would reduce the monthly pace of net asset purchases to €15 billion until the end of December 2018 and then end net asset purchases.

Lest we forget it will be twisting by the pool this summer and beyond.

Third, it intended to maintain its policy of reinvesting the principal payments from maturing securities purchased under the APP for an extended period of time after ending net purchases, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

One of the biggest beneficiaries does not seem to merit a mention so let me help out. The various Euro area governments will be grateful for the help to fiscal policy via lower borrowing costs especially Mario’s home country because after the election result the bond market there has looked more vulnerable ( 10 year yield 2.65%). Some may think that the new Vice President the ex Spanish Finance Minister was appointed to keep the ECB reminded about this but whatever it does pose questions about the claimed independence. After all it was only at the last press conference that we were told the ECB was struggling to find him a specific role implying he lacked the skills required.

But looking ahead the sovereign bond book will head towards 2.1 trillion Euros and then stay there. So we move on with the nagging worry that people are still drinking from the punch bowl with the band at full volume.

What happens next?

This morning’s monetary data provided some food for thought.

The annual growth rate of the broad monetary aggregate M3 increased to 4.4% in June 2018 from 4.0% in
May, averaging 4.1% in the three months up to June. The components of M3 showed the following
developments. The annual growth rate of the narrower aggregate M1, which comprises currency in
circulation and overnight deposits, stood at 7.4% in June, compared with 7.5% in May

In terms of economic outlook we see that the narrow money supply has stabilised overall at a lower level confirming a weaker economic trajectory. Looking further ahead broad money growth has improved but against that inflation has risen.

The ECB will be pleased to see an improvement in credit provided to businesses but I think that is more of a lagging ( from the period of growth seen last year) than a leading indicator.

A Space Oddity

Strangely perhaps the biggest challenge to the shiny happy people economic view in the Euro area has come from the ECB itself.

The view was also reiterated that the observed slowdown could, to some extent, be seen as a natural development in a maturing expansion after many years of growth above potential.  ( ECB July Minutes )

Er haven’t we just seen many years of growth below potential? I know recently things improved but have the credit crunch and the Euro area crisis just been redacted? Also as so often for central bankers we see such thoughts are driven by a rather downbeat outlook.

An increasing number of countries and sectors were starting to run into capacity constraints and labour shortages, implying a “structural” levelling-off of growth,

If true that is a bit grim.

Banks

Problems here never really go away and claiming “many years of growth above potential” trims the list of possible excuses quite drastically. There is the ongoing issue of money laundering and corruption in the Baltic nations and of course there is the Italian version.

The ECB appears to have lost patience with Carige, which although worth a mere 500 million euros is one of Italy’s top 10 biggest lenders by assets. It has rejected the Genoa-based bank’s current capital plan, and given it until year end to raise its total capital ratio to 13.1 percent, almost 90 basis points above the current level.  ( Reuters )

Comment

As you can see the picture on the surface looks good for the ECB and it is true there have been improvements. I expect Mario to defend the ongoing QE and negative interest-rates by pointing out that what he considers to be core inflation is at 1.2% below target. But the old punch bowl argument does pose questions especially as the man who made the original case could not have been aware of how large a modern punch bowl actually is. The vulnerability is to any combination of a further slowing in the economy and pick up in inflation. That will be there for a while as the ECB intends to maintain the size of its stock of QE  as well as having no plans to raise interest-rates.

This entailed the expectation that policy rates would remain at their present levels at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remained aligned with the Governing Council’s current expectations of a sustained adjustment path. ( ECB July Minutes)

Putting this another way I note that the Taylor Rule would according to the Wall Street Journal have interest-rates at 2.5%. I am no great fan of automatic rules but that is quite a gap and widens if you note the -0.4% deposit rate rather than the 0% rate some like to emphasise. Which returns to the question of why if things are so good we remain enmeshed in zero and indeed negative interest-rates?

 

 

 

 

 

 

 

Can negative interest-rates prevent a recession in Denmark?

One of the features of the response to the credit crunch was a general reduction in interest-rates. This was followed later by Quantitative Easing and around the Euro area in particular by further reductions in interest-rates. This was evidenced by Denmark where its Nationalbanken cut its current account rate to 0% in June 2012 where it remains. Even more so by its certificate of deposit or CD rate which moved into negative territory in July 2012 at -0.2% and is now -0.65% having been as low as -0.75%. So after raising interest-rates almost unbelievably as the credit crunch hit the Nationalbanken became an enthusiastic cutter of them and before we get to the impact on the Danish economy we need to remind ourselves that there is an external or foreign restraint at play here.

Denmark maintains a fixed-exchange-rate policy vis-à-vis the euro area and participates in the European Exchange Rate Mechanism, ERM 2, at a central rate of 746.038 kroner per 100 euro with a fluctuation band of +/- 2.25 per cent.

So it is no great surprise to note that Danish interest-rates were in effect sucked lower by the impact of Mario Draghi’s “Whatever it takes ( to save the Euro) speech and policies. Of course all interest-rate policies have external and internal economic implications but when you have such an explicit one the external takes over at times of stress. For choice I would call it a pegged currency rather than fixed as whilst it is unlikely it could more easily change the rate than it could leave the “irreversible” Euro if it had joined it. Anyway here is how the Nationalbanken  reviewed events back in the summer of 2012.

For the first time in its nearly 200-year history, one of Danmarks Nationalbank’s interest rates is negative. Negative monetary-policy interest rates are also unique in an international perspective.

They were not lonely for long!

The economic situation

At the end of last month the Nationalbanken told us this.

The Danish economy is in a boom where the
growth outlook is slightly better than the potential……. There is consensus that labour market
pressures will intensify.

We get the picture although the discussion with the Danish Economic Council did have something from the left field.

In addition, the calculation assumes an increase in the retirement age by 12 years relative to today.

Really? It seems for best that they think that the public finances are in good shape. Although I note that the enthusiasm for easy monetary policy does not spread to fiscal policy.

This should not be perceived as scope for fiscal policy accommodation within a foreseeable time horizon. The cyclical position must be taken into account.

Returning to the economic situation we were told this back in March.

The upswing continued in the 2nd half of 2017 and the Danish economy has now entered a boom phase. Labour market pressures have increased, but so far the upswing has been balanced.

That is Danmarks Nationalbank’s conclusion in a new projection of the Danish economy, in which growth in the gross domestic product, GDP, is expected to be 1.9 per cent this year, 1.8 per cent next year and 1.7 per cent in 2020.

We need a caveat for those who think that these days we need recorded growth of 2%  per annum just to stand still but Nationalbanken Governor Lars Rhode is not one of them.

The Danish economy is booming

In fact the outlook is so good that the brakes may need to be applied although it is revealing that Governor Rhode seems to have forgotten that the task below is usually considered to be the role of monetary policy because it is more flexible.

So the government should be prepared to introduce preventive fiscal tightening at short notice if there are signs that the economy is overheating.

The boom

We get a new perspective on the concept of boom if we note that at current prices the GDP of Denmark was 537.9 billion Danish Krone in the first quarter of 2017 and 537.3 billion in the first quarter of this year. This was driven by this.

Gross domestic product fell 0.6 percent in the third quarter from the previous three-month period, Statistics Denmark said on Thursday ( Bloomberg).

In fact we know that on the measure looked at above it fell by 0.8% and unknown to Bloomberg back then it had also fallen by over 1% in the second quarter so there had in fact been a recession in the boom. How can this be? Well there was an element of the Irish problem.

The reason is primarily a large payment of a Danish owned patent which is temporarily accounted for as service exports in Q1 2017. That leaves Q1 GDP at a massive 2.3% q/q growth and Q2 at -1.2%. Q3 turned out even worse than previously suggested at -0.8% but it is largely attributed to negative stock building and the above mentioned sudden stop in car sales. ( Danske Bank ).

This meant that if you looked at 2017 as a calendar year things looked like a boom. From the Financial Times.

Gross domestic product increased 2.1 per cent for the year overall, the country’s best performance since 2006. Jan Størup Nielsen, chief analyst at Nordea, said the country is now “running at full capacity” for the first time in 10 years, and said the solid performance “will likely continue in 2018”.

Yet if you look from the latest data then the economy is smaller than a year before! If we move to the cause here is the likely factor.

However, most of Denmark’s most valuable patents are held by pharmaceuticals companies and several economists pointed to a payment made to Danish group Forward Pharma last January. Nasdaq-listed Forward received a $1.25bn payment from US biotech Biogen as part of a dispute over patents for multiple sclerosis treatments. Forward chief executive Claus Bo Svendsen said the data showed “a nice time-wise correlation with our deal with Biogen”.

House Prices

From the Nationalbanken.

As a result of the gradual shift from bank loans to
mortgage loans in recent years, mortgage lending
continues to drive lending growth.

They will need to drive it a bit faster as at the end of 2017 there was a dip in house prices after a spell of rises which in the light of the negative interest-rates era you may not be surprised to learn began in 2012.  The 85.7 of the index was replaced by 111 in the autumn of last year but it ended the year at 109.1 . Like many capital cities Copenhagen is now under much cooler pressures than were seen before.

Comment

Let me open with this from Bloomberg yesterday.

In the world-record holder of negative rates, there’s been another eye-catching development.

Danes are richer than ever before, according to central bank data on savings and home equity. But they’re spending less, in relative terms. The gap between private consumption and household wealth is the biggest it’s been in three decades.

Those familiar with my analysis will not be surprised unlike those Bloomberg go on to quote. This is because there is a large group of losers as those who do not own property face inflation which does not show up in the Consumer Price Index which is at 102.2 compared to 100 in 2015. Whereas the winners are really only those who have sold and made a profit or more implicitly those who have used higher prices to borrow more.

So wealth is not what is used to be as we get another reminder that GDP isn’t either.

Though private consumption did inch up 0.9 percent in the first quarter, it wasn’t enough to prevent the economy from shrinking on an annual basis.  Danske says GDP growth this year probably won’t exceed 2 percent.

Furthermore will Denmark be influenced by the slowing in the UK and Euro area and with interest-rates already negative how would it respond in such a scenario?

 

 

An expansion of fiscal policy in the Euro area might help to keep Italy in it

After the action or in many ways inaction at the Bank of England last week there was a shift of attention to the ECB or European Central Bank. Or if you prefer from Governor Mark Carney to President Mario Draghi. This is because tucked away in a rather familiar tale from him in a speech in Florence was what you might call parking your tanks on somebody else’s lawn. It started with this.

One is the ECB’s OMTs, which can be used when there is a threat to euro area price stability and comes with an ESM programme. The other is the ESM itself.

Actually rather contrary to what Mario implies Outright Monetary Transactions or OMTs were never required as the ECB instead expanded its bond puchases via the Quantitative Easing programme which is ongoing currently at a flow of 30 billion Euros a month. One might also argue the European Stability Mechanism has caused anything but in Greece however the fundamental point is that via such mechanisms monetary policy has slipped under and over and around the border into fiscal policy. For example after the progress in the coalition talks in Italy the financial media has moved onto articles about the Italian national debt being un affordable when in fact the factor that has made it affordable is/are the 342 billion Euros of it that the ECB has purchased. The Italy of 7% bond yields at the time of the Euro area crisis would not have reached now in the same form whereas the current Italy of around 2% yields has.

But there is more than tip-toeing onto the fiscal lawn below.

So, we need an additional fiscal instrument to maintain convergence during large shocks, without having to over-burden monetary policy. Its aim would be to provide an extra layer of stabilisation, thereby reinforcing confidence in national policies.

As no doubt you have already recognised that particular lawn has been mined with economic IEDs as Mario then implicitly acknowledges.

And, as we have seen from our longstanding discussions, it is certainly not politically simple, regardless of the shape that such an instrument could take: from the provision of supranational public goods – like security, defence or migration – to a fully-fledged fiscal capacity.

The only one of those that is pretty non contentious these days is the security issue and that of course is because of the grim nature of events in that area. However the movement of ECB tanks onto the fiscal lawn continued.

But the argument whereby risk-sharing may help to greatly reduce risk, or whereby solidarity, in some specific circumstances, contributes to efficient risk-reduction, is compelling in this case as well, and our work on the design and proper timeframe for such an instrument should continue.

All of that is true and just in case people missed it then the ECB broadcasted it from its social media feeds as well.

Why has Mario done this?

One view might be that as he approaches the end of his term he feels that he can do this in a way he could not before. Another ties in with a theme of this website which is to use the words of Governor Carney that monetary policy may not be “maxxed out” but there are clear signs of fatigue and side-effects. Mario may well have had a sleepless night or two as he thinks of his own recent words about the Euro area economy.

When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries. It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators.

Where this fits in with my theme is that this is happening with an official deposit rate of -0.4% and not only an enormously expanded balance sheet but ongoing QE. Thus the sleepless nights will be when Mario wonders what  to do if this also turns out to be ongoing? The two obvious monetary responses have problems as whilst what economists call the “lower bound” has proved to be yet another mirage that is so far and plunging further into the icy cold world of negative interest-rates increases the risk of a dash to cash. The second response which ties in with the issue of policy in Germany is that the ECB is running out of German bunds to buy so firing up the QE operation again is also problematic.

Fiscal Policy

The problem puts Mario on an Odyssey.

And if you’re looking for a way out
I won’t stand here in your way.

In terms of economic theory there is a glittering prize in view here but sadly it only shows an example of what might be called simple minds. This is because at the “lower bound” for interest-rates in a liquidity trap  fiscal policy will be at its most effective according to that theory. So far go good until we note that the “lower bound” has got er lower and lower. There was of course the Governor Carney faux pas of saying it was at 0.5% and then not only cutting to 0.25% but planning to cut to 0.1% before the latter was abandoned but also some argued it was at 0% and of course quite a bit of the world is currently below that.

So Mario is calling for some fiscal policy and as so often all eyes turn to Germany which as I have pointed out before is operating fiscal policy but one heading in the opposite direction as I pointed out on the 20th of November.

Germany’s federal budget  surplus hit a record 18.3 billion euros ($21.6 billion) for the first half of 2017.

This poses various problems as I then pointed out.

With its role in the Euro area should a country with its trade surpluses be aiming at a fiscal surplus too or should it be more expansionary to help reduce both and thus help others?

As you can see Mario is leaving the conceptual issue behind and simply concentrating on his worries for 2018. This of course is standard Euro area policy where changes come in for an emergency and then find themselves becoming permanent. Although to be fair they are far from alone from this as I note that Income Tax in the UK was supposed to be a temporary way of helping to finance the Napoleonic wars.

Comment

This speech may well turn out to be as famous as the “Whatever it takes ( to save the Euro) one. In terms of his own operations Mario has proved to be a steadfast supporter of it but the monetary policy ammunition locker has been emptied. It is also true that it means he has been something of a one-club golfer because the Euro area political class has in essence embraced austerity and left Mario rather lonely. Now his time is running out he is in effect pointing that out and asking for help. Perhaps he is envious of what President Trump has just enacted in the United States.

There are clear problems though. We have been on this road before and it has turned out to be a road to nowhere in spite of many talking heads supporting it. In essence it relies in the backing of Germany and it has been unwilling to allow supranational Eurobonds where for example Italy and Greece could borrow with the German taxpayer potentially on the hook. If anything Germany seems to be heading in the direction of being even more fiscally conservative.

If we look wider we see that at the heart of this is something which has dogged the credit crunch era. If you believe one of the causes of it was imbalances well the German trade surplus has if anything swelled and now it is adding fiscal surpluses to that. Next if we look more narrowly there are the ongoing ch-ch-changes in Mario’s home country Italy. From the Wall Street Journal.

Both parties vowed to scrap or dilute an unpopular pension overhaul from 2011 that steadily raises the retirement age. Economists say the parties’ fiscal promises, if enacted in full, would greatly add to Italy’s budget shortfall, likely breaking EU rules that cap deficits at 3% of gross domestic product. Italy’s public debt, at 132% of GDP, is the EU’s highest after Greece.

So is it to save the Euro or to keep Italy in it?

Where next for the Euro exchange-rate?

As we start a new week the focus will be shifting to the Euro area and its economy and exchange-rate. The reason for this comes from my article of last Wednesday which concluded with this.

The ECB finds itself in something of a dilemma. This is because it has continued with a highly stimulatory policy in a boom and now faces the issue of deciding if the current slow down is temporary or not? Even worse for presentational purposes it has suggested it will end QE in September just in time for the economic winds to reverse course.

Such thoughts were strongly reinforced in the Thursday press conference when we started with an Introductory Statement mentioning moderation.

Following several quarters of higher than expected growth, incoming information since our meeting in early March points towards some moderation, while remaining consistent with a solid and broad-based expansion of the euro area economy

At this point we merely have the ECB Governing Council covering itself either way as if they economy picks-up they will emphasis the latter bit and if it slows down they will tell us they warned about moderation. But then in his replies to questions President Draghi took things a step or two further.

 It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries. It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators.

As I pointed out on Friday if we translate from the language of central bankers the use of “significant sharp declines” is of importance as these days they consider it their job to stop that! If you had negative interest-rates and a balance sheet of over 4.5 trillion Euros it would give you food for thought. If we look at the next bit we can see that it did as it occupied so much time they did not discuss monetary policy at all.

 First of all, the interesting thing is that we didn’t discuss monetary policy per se. All Governing Council members reported on the situation of their own countries.

So they decided that as there is nothing they can do in the short-term and policy is already expansionary there was nothing to do. Also they were again caught on the hop.

And these declines were sharp and in some cases, the extent of these declines was unexpected.

Today’s monetary data

This will have attracted the attention of Mario Draghi and the Governing Council so let us start with the headline.

The annual growth rate of the broad monetary aggregate M3 decreased to 3.7% in March 2018,
from 4.2% in February.

Now let us compare it with the press conference Introductory Statement.

Turning to the monetary analysis, broad money (M3) continues to expand at a robust pace, with an annual growth rate of 4.2% in February 2018, slightly below the narrow range observed since mid-2015.

If we look through the rhetoric we see that it was already below the range that had led to the recent stronger economic growth. If we use the rule of thumb that broad money growth can be divided between economic growth and inflation we see that one of them will be squeezed. With the price of a barrel of Brent Crude Oil remaining around US $74 per barrel it seems that there will be upwards pressure on inflation from this source which may further squeeze output.

In terms of the immediate future then it is narrow money which gives us the best guide and it too was a disappointment.

The annual growth rate of the narrower aggregate M1, which includes currency in circulation and overnight deposits, decreased to 7.5% in March, from 8.4% in February.

This series peaked at just under 10% last autumn so we can see that from it we will be expecting something of a slow down over the next 6 months or so.

Is this the impact of QE?

The impact on March may well be the consequence of the reduction in monthly QE purchases from 60 billion Euros a month to 30 billion which began in January. The monthly numbers for M1 growth have gone 51 billion, 31 billion and now 20 billion so whilst it is not that simple as the numbers are erratic I think it added to an existing trend.

This leaves the ECB mulling the irony that it chose to do less as the economy weakened. Or that the expansion needs a continuous dose of the economic pick me up and cannot thrive otherwise.

What about credit?

When you consider that the taps are supposed to be fully open it was not that special.

The annual growth rate of total credit to euro area residents decreased to 2.9% in March 2018, compared
with 3.4% in the previous month.

Whilst it may not look like it from the number above but March was better than February if you look into the detail such as this one.

In particular, the annual growth rate of adjusted loans to households increased to 3.0% in March, from 2.9% in February, and the annual growth rate of adjusted loans to non-financial corporations increased to 3.3% in March, from 3.2% in February.

But such numbers are more of a lagging indicator than a leading one so we are left with a downbeat view.

Comment

In terms of first quarter data the score is 2-1. On the downside we have seen GDP ( Gross Domestic Product) growth in Belgium dip to 0.4% and more of a fall in France to 0.3%. On the other side Spain shrugged it off and grew by 0.7%. As even the German Bundesbank is expecting a slow down there it seems set to be a weaker quarter for Euro area growth and that will not have been helped by the weakness in the UK.

This means that two of the supports for the level of the Euro are weakening. The first is the fading and perhaps end of the Euroboom as the better economic growth data supported the currency. The second is a potential consequence which is the planned reduction in QE in September where eyes will soon turn to this bit from the ECB.

are intended to run until the end of September 2018, 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.

Actually the inflation issue is also on the cards today after this from Italy.

In April 2018, according to preliminary estimates, the Italian consumer price index for the whole nation (NIC) increased by 0.1% on monthly basis and by 0.5% compared with April 2017.

So a long way from the just below 2% objective and Portugal at 0.3% was similar. Whilst I expect the new higher oil price to change things we could see a shake-up in the plans for QE in 2018. Whilst we know it is nor as simple as more QE or more negative interest-rates equals a weaker currency a shift like that seems likely to have an effect.

Meanwhile as ever life is complex as according to the oil trader @chigrl a higher oil price boosts the value of the Euro.

Thus the foreign currency reserve balances of these oil exporting countries, in a sense, is broadly reflected by the price of oil. ……However, data also shows that they invest part of their reserves in EUR, as they sell a large share of their production to the Eurozone.

Which leads to this.

Thus, when the price of oil falls, this means that a smaller portion of USD is transferred to EUR, thus contributing to a depreciation of the currency. Inversely, when the price of oil increases, a larger portion is transferred to EUR, contributing to the appreciation of the currency.

This gets exacerbated when some try to game this.

For this reason, many funds lock their positions in EUR/USD with those in crude oil.

 

The soaring price of shares in the Swiss National Bank poses many questions

We find ourselves today looking at a country which exhibits many of the economic themes of these times and one of them is brought to mind by this from the fastFT twitter feed.

US 10-year bond yields creep further towards 3% milestone

The fact that the 10-year Treasury Note yield is 2.99% is part of what is called “normalisation” of interest-rates and bond yields, although care is needed as we have been here before. But my subject of today can say the equivalent of “bah humbug” to this as it has a 10-year yield of a mere 0.13%. If we look back and take a broad sweep it has had this yield averaging around 0% for the past five years with a low of -0.6%. In fact Switzerland can still borrow out to the 8 year maturity and be paid for doing so as its yields are negative out to their. So the old normal remains a distant dream ( or nightmare depending on your perspective) and let me throw in a thought. There are arguments you should use such times to borrow and invest but the Swiss have pretty much set their face against this.

The Confederation wants to ensure room for manoeuvre for future generations by means of a sustainable fiscal policy. It has been pursuing a strategy of a balanced budget in the medium-term and a low level of debt since the start of 2000…………Thanks to the debt brake, it has been possible to considerably reduce federal debt ( Department of Finance February 2nd 2018).

According to the OECD it has a national debt of just under 43% of annual GDP. Of course there is a virtuous circle between bond yields and fiscal surpluses but for these times Switzerland is rather abnormal to say the least.

Negative Interest-Rates

The Swiss National Bank has contributed to the above via this.

Interest on sight deposits at the SNB is to remain at –0.75% and the target range for the three-month Libor is
unchanged at between –1.25% and –0.25%.

Money rates are at -0.73% if you want precision and as Swiss Banks have some 573 billion Swiss France deposited at the SNB there will be an icy chill felt although of course the SNB did take measures to protect the “precious”. Nonetheless there is a cost. From Reuters.

Swiss banks paid 970 million Swiss francs ($1 billion) in negative interest rate charges in the first six months of 2017, according to central bank data, up 40 percent year-on-year as clients continue to hoard cash.

Interesting isn’t it that so far ( and we have over 3 years now) there has been little impact on cash holdings? We learn a little more about negative interest-rates from this as there does not seem to be much of an adjustment so far.

Boom!

Last week saw what was quite an event. From Reuters.

The Swiss franc fell to a three-year low of 1.20 against the euro on Thursday as a revival in risk appetite encouraged investors to use it to buy higher yielding assets elsewhere, betting on loose monetary policy keeping the currency weak.

This took us back to January 15th 2015 when this happened.

The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it.

This was how interest-rates were reduced to -0.75% as the previous policy of “unlimited intervention” fell to earth. It was not that the SNB was running out of reserves as when you intervene against a strong currency you are selling something you do have an unlimited supply of at least in theoretical terms. But it was a combination of the scale of interventions  required and the side-effects and consequences which in this instance broke the bank policy.

As ever a move in interest-rates of 0.5% was in currency terms like putting a Band-Aid on a broken leg and the Swiss Franc surged.

; in midMarch 2015 it was at CHF 1.06 per euro, constituting a 12% appreciation against the minimum exchange rate of CHF 1.20 per euro in place until mid-January. ( SNB)

For newer readers wondering why the Swiss Franc was so strong it had been kicked-off by the reversal of the Carry Trade. If you look back in time on here you will see analysis of what I called the Currency Twins of the Swissy and the Japanese Yen who were affected by enormous levels of foreign borrowing pre credit crunch. This strengthened those two currencies after the credit crunch as some rushed to get out and of course the currency markets noted that at least some were desperate to get out.

This had a substantial human cost as many mortgage and business borrowers in Eastern Europe had taken advantage of low interest-rates in the Swiss Franc. They then faced surging monthly repayments when they were converted into the currency in which they had an income and quite a crisis was started. Of course doing such a thing was stupid but care is needed as whilst you should be responsible for your own actions it is also true that the banking sector did its best to miss lead on this issue and hide the risks faced.

Hedge Fund

On the road to the 15th of January 2015 the Swiss National Bank built up an extraordinary amount of foreign exchange reserves. In fact since there it has also intervened from time to time but on a much more minor scale.

The SNB will remain active in the foreign
exchange market as necessary, while taking the overall currency situation into consideration.

Which according to the 2017 annual report has led to this.

The level of currency reserves has risen by more than
CHF 700 billion to almost CHF 800 billion since the onset of the financial and debt crisis in 2008. The increase is largely due to foreign currency purchases aimed at curbing the appreciation of the Swiss franc.

Which has led to this as I pointed out on the 15th of March.

The majority of the SNB’s foreign currency investments are in government bonds, bonds issued by foreign local authorities (e.g. provinces and municipalities) and supranational organisations, as well as corporate bonds, or are placed at other central banks. The proportion of equities is one-fifth. Two-fifths of the foreign currency investments are denominated in euros, and more than one-third in US dollars. Other important investment currencies are the pound sterling, yen and Canadian dollar.

It has become rather a large hedge fund as we note the diversification into equities. Also we get a hint of why Euro area bonds have done so well as not only has the ECB been buying via its QE program so has the Swiss National Bank. A rally driven by competing central banks?

Comment

There is a lot to consider here as for example if we start with an international perspective what will happen to equities if the Swiss National Bank should stop buying and start selling? The bellweather of this is Apple where according to NASDAQ it owned some 19.1 million shares at the end of 2017. Care is needed as we are just below the 1.20 level and the SNB intervened at considerably worse levels but it could decide to reverse course soon at least in part unless of course it is singing along to the ladies of En Vogue.

Hold me tight and don’t let go
Don’t let go
You have the right to lose control
Don’t let go

Don’t let go
Don’t let go

Meanwhile staying with the theme of equities there is the ongoing issue of shares in the Swiss National Bank itself.

This has led to quite a lot of speculation that one day the private shareholders might get a share so to speak. This is how it looked back in October.

Less than a month after its stock smashed through the 3,000-franc-a-share barrier, SNB shares hit an intraday high of 4,324 on Wednesday and were trading as high as 4,600 on Thursday. The stock has tripled in value from a year ago, repeatedly confounding market watchers by regularly hitting records.

It is now 8380 Swiss Francs according to Bloomberg. Should shares in a central bank be doing this? The answer is clearly no as we mull a central bank which is partly privately owned.

Moving back to Switzerland I note many are calling this a success for the SNB. Odd isn’t it that this way round the counterfactuals that many are so keen on when things go wrong for central banks seem to get lost in a fog of amnesia? The truth is we do not know as currency trends ebb and flow but there is of course another factor. Any economic slow down would start currently with interest-rates at -0.75% posing the question of what would happen next? Perhaps they will run into Korean Won. From February.

The swap agreement enables Korean won and Swiss francs to be purchased and repurchased between the two central banks, up to a limit of KRW 11.2 trillion, or CHF 10 billion.