Tag Archives: ecb

Keep Monetary Policy and Structural Reform Separate

European QE alleviates the need for structural reform. Or so Merkel and Weidmann say. The argument here is that if the ECB eases monetary policy in an effort to improve economic conditions in Southern Europe, that enables Southern European countries to kick the can down the road and delay on enacting structural reforms.

This is hogwash.

Now, I do not mean to say structural reforms are not necessary. Jay Shambaugh, an economics professor at Georgetown, descries the current European malaise was the result of three interconnected crises: a banking crisis, a sovereign debt crisis, and a growth crisis. Given the crisis in growth, structural reforms such as “deregulating product or retail markets, streamlining rules for investment or starting businesses, implementing policies that foster innovation, or removing barriers to entry in various services professions” must play a role.

But central bankers should not try to be “enforcers”. The Bank of Japan tried this in the 1990’s. In his article titled “The Political Economy of Deflationary Monetary Policy“, Adam Posen argued that there was a broadly held belief at the Bank of Japan belief that tight money was necessary to encourage economic dynamism. As an example, Posen draws on remarks by BOJ Governer Hayami in 2000:

“Mr. Hayami also repeated his view that the zero interest rate policy was undermining structural reform in Japan and preventing the rise of promising high-tech industries. “If we retain zero interest rates indefinitely, these places will lose vitality…and it will end up being a minus for Japan’s economic recovery.”

Given the lack of evidence that tight money can encourage structural reforms, Posen concludes “that ‘creative destruction,’ invoked and praised repeatedly in Hayami’s speeches, [was] the motivating ideology”.

The fact that the German leadership is committing the same errors as the Japanese leadership in the 1990’s shows that this obsession with structural reform is deep seated in the minds of “very serious people”.

Syriza’s victory also shows that democracies do not walk willingly into structural reform when growth is moribund. Instead, they are likely to elect radical parties that promise to overthrow these reforms. And so instead of slightly higher inflation which would help Greece more easily accomplish an adjustment in real wages, we instead get a party whose platform includes higher minimum wages and public sector pensions. As Scott Sumner has complained, “conservatives seem so opposed to slightly higher inflation that they’ll often end up tacitly or explicitly supporting much more statist policies instead.” Unfortunately, we see exactly this playing out in Greece today.

Fortunately, Draghi seems to have a clear head on the issue of structural reform.

“What monetary policy can do is create the basis for growth,” he said. “But for growth to pick up, you need investment; for investment, you need confidence; and for confidence, you need structural reform.”

One would hope that German leadership would also adopt this attitude. Insist on structural reform, but recognize that the only way to get there is through a monetary policy that takes the needs of all Euro nations into account.

Will Europe Finally Join the QE Bandwagon? (Revised)

Europe has struggled to rebound from the Great Recession.  A few years ago, it appeared that the EU and the United States were recovering at roughly the same pace, as shown by this graph of World Bank data on GDP growth rates.  In 2012, the EU dropped off of the path to recovery, posting a -0.4% growth rate, while the United States continued to chug on at around 2% growth per year.  This divergence was largely a product of the two different policy approaches taken by the central banks of each economy.  In the US, the Fed engaged in three separate rounds of large monthly bond purchases, or quantitative easing, with the goal of expanding the money supply and lowering interest rates.  In contrast, the European Central Bank responded with the European Financial Stability Facility to provide liquidity to EU members, and several European states undertook austerity policies.  It may be slightly naive to attribute all of the US economy’s recovery to QE, but it certainly appears to have been incredibly effective.

So why did the EU not even attempt QE while the Fed was rolling out several rounds of it?  One big obstacle that the ECB faces is the fact that it is composed of a multitude of national central banks, making it far more difficult to coordinate asset purchases.  However, it appears that the time may have finally come for the European Central Bank to enlist the help of QE.  As reported in the Wall Street Journal, the ECB’s executive board has proposed a 12-month (at minimum) round of QE, composed of asset purchases of €50 billion per month.  The bank’s governing body will meet Thursday to discuss the proposal.  As noted by MIT professor Athanasios Orphanides in the Journal article, “the potentially open-ended nature of the program—the idea the ECB could continue beyond a year—is a bright spot that could give the program additional power”, since many economists believe one of the core strengths of QE is the effect on the market that expectations of aggressive future monetary policy can have.  More specifically, a central bank indicating that it wishes to keep interest rates low will have far more credibility if it is engaging in QE, since it is exposing itself to the risk of losses on the assets it’s buying up if rates were to rise, as pointed out by an article in The Economist that gives a fantastic overview of the implications of QE.

As news of the potential ECB actions broke, the euro fell against the dollar – good news for the multitude of European states that rely heavily on exports to fuel their economy.  Italian prime minister Matteo Renzi was one of those who welcomed the news, who claimed that he dreams of parity between the Euro and the Dollar in an interview with the Wall Street Journal earlier today, believing that it would grant Europe greater economic flexibility.  However, it is not good news for everybody – German officials oppose the ECB plan, as noted in the first Journal article, since German taxpayers have concerns that they would be responsible for the more risky debt of other European countries.

Since I originally wrote this post, the official ECB press release has been issued, and thus some new pieces of information have emerged.  The official plan is more ambitious than what was originally proposed by the ECB exec board: the monthly purchases will be €60 billion each, and will continue through September 2016 at minimum, far longer than the original 12 months.  This would result in about a €1.1 ($1.24) trillion injection into the eurozone, making it about 75% the size of the Fed’s QE3 program (which was roughly $1.7 trillion), in a very similar format.  The Germans are likely to be pleased with the loss-sharing arrangement: only 20% of asset purchases will be subject to risk-sharing, which, in my opinion, is a necessary arrangement to ensure that every member of the monetary union is convinced.  It’s worth noting that the ECB is strictly targeting inflation with this policy, whereas the Fed’s primary goal with QE was to put downward pressure on interest rates.  It is this disparity in policy goals that leaves me with doubts about how effective QE will be for the eurozone: interest rates are already quite low, so the ECB stands to gain little ground in that respect.

Get Zero Interest Rates Till June!

The Fed held its FOMC meeting this past Tuesday and Wednesday, January 27th to the 28th of 2015, discussing several different aspects of monetary policy to “foster maximum employment and price stability.” Lately, there has been a lot of talk about a rumored interest rate increase that is forecasted to occur sometime this year. Fortunately, the Fed has decided to leave interest rates where they are on account of the falling inflation rates throughout the US, for which they listed several reasons. They spoke on the falling oil prices, the ECB’s decision to buy over a trillion Euros worth of bonds, and the dollar’s appreciating value. Ultimately, interest rates are still expected to increase in June of this year, and many still fear this day.

A USA Today article titled “Fed likely to continue to signal mid-2015 rate hike” states “The Fed typically raises interest rates to keep inflation from spiraling too high as the economy and labor market heat up and lowers rates to spur growth. The unemployment rate has fallen from 6.7% to a near-normal 5.6% over the past year, providing support for adhering to Fed policymakers’ forecast for the first rate hike in June.” Should the Fed increase interest rates, many negative events may occur. The most likely result of this increase would be an immediate shock to the stock market. Investors like conditions where money is cheap, and higher interest rates mean it is effectively more expensive to borrow. The same goes for mortgages, loans, and credit. People would ultimately see a decrease in the purchasing power of their dollars, and a rise in prices everywhere. Historically, higher interest rates have been signs of an economic recession, however the Fed doesn’t have much of a choice.

Some expect that the Fed shall continue printing money and buying securities to keep interest rates artificially low. That is entirely within the realm of possibility, however eventually the Fed has to raise interest rates or inflation will devalue the dollar to a worthless status. It’s going to be a risky decision for the Fed, and had they raised interest rates a long time ago, it may have been a smarter move. Economic crashes have always occurred cyclically. Never for the same exact reason, always the same way. As with the 2008 subprime mortgage bubble, we are now faced with an even greater bubble that must be deflated. What remains to be seen is which needle the Fed chooses to use this time.

What Price Level Targeting Could do for Europe

There’s more to asset purchases than size. In addition to announcing large bond purchases of €60 bn per month, ECB president Mario Draghi suggested that asset purchases could continue until the ECB hit its inflation target of 2%.

This resembles QE 3, in which the Fed committed to asset purchases until unemployment fell below 6.5% or inflation rose above 2.5%. It also resembles recent events at the Bank of Japan. When Kuroda saw that the Bank of Japan would not be hitting its inflation target, he had the BOJ raise the rate of asset purchases by 30 tr. yen per year — from 50 to 80 tr yen. If the ECB follows up on this open ended commitment, it could be the bold new start of a “Draghi Framework” in which the ECB commits to hitting its inflation target through asset purchases.

This might not be enough. One problem with monetary policy at the zero lower bound is that the only way to lower real interest rates (without introducing negative paper currency interest rates) is to increase expected inflation. If central banks define their own responsibility in terms of hitting an inflation target, then raising inflation expectations is tantamount to “credibly promising to be irresponsible”. To get people to raise their inflation expectations now, the ECB would need to convince people that the central bank will let inflation run too high for a period in the future — something that’s not credible when the inflation target has historically centered around 1.50–1.75%.

One way around this is to commit not to an inflation target but rather a price level target. Instead of targeting a growth path for the price level, the ECB would instead commit to making sure the price level reaches a predetermined path. So if the ECB undershoots one year, its target would have it try to generate more inflation in the next.

Let’s consider what this means given the history of the price level in the Eurozone.

What’s evident from the graph is that the path of the price level was pretty steady up until 2012, and since then it has leveled off. This collapse in the price level growth rate (aka inflation) is even more stark from looking at year over year inflation rates.

Year over year inflation is negative. An inflation target would commit the central bank to raise that up to 2%. A price level target would commit to raising that level inflation above 2% for an extended period of time in order to fill in the gap caused by the persistent lack of inflation over the course of the last year.

(Ignore the 2012 bump — it was the result of VAT tax changes that should have no relevance for monetary policy)

But the key part of a price level target is that it implies larger and larger levels of inflation if the central bank doesn’t hit its target. If the target is a 2% price level path, and inflation is only 1% this year, that implies that the central bank is committing to a 3% inflation target the year after. If inflation stays at 1%, then the inflation target becomes 4%. If the central bank can do this credibly, then expected inflation increases as the experience at zero lower bound gets longer. This lowers real interest rates and allows the central bank to get more traction.

And why might we think this threat is credible? As I discussed before, if a central bank can’t raise the price level then that would imply absurd abilities to change real economic conditions.

Price level targeting gets around Krugman’s “credible irresponsibility” line because the central bank redefines what it means to be responsible. Higher inflation becomes responsible because it’s done in the name of hitting a price level target.

The ECB made an important step towards restoring nominal stability in the Eurozone with QE. But if the ECB finds itself needing to bring out more firepower, a price level target would be one way for the ECB to get more traction at the zero lower bound.

Originally posted on Medium.

Weakened Euro

The Euro has been depreciating relative to almost all other currencies for a while now. The euro used to be able to buy ~1.40 American Dollars, but now has fallen to just 1.11 US Dollars. This has caused mixed opinions on whether this is a good thing for the Eurozone currently. This depreciating of the currency will bring many benefits to the members of the Eurozone and help get their economy, which has been struggling the most out of all major developed countries following the Great Recession of 2008. This will be done by the influx of demand for now cheap European goods. Consumers from all over the world will flock to the Eurozone as goods produced there have become much cheaper. A simple example of why consumers will flock to European goods is: imagine that France produces widgets. France’s widget costs 100 euros. As late as one year ago, this widget would have cost an American $140. This is because to buy a widget, an American must first exchange his American dollars for European euros. The exchange rate was ~1 euro=1.4 U.S dollars. Today though this same consumer can purchase this widget for only $111. This will cause a lot more consumers to demand these widgets and able to afford them! As Tommy Stubbington wrote in his Wall Street Journal article, Parity Rumblings Emerge Over Euro, “”The euro area stands to be a winner of the currency wars in 2015,” said Jonathan Baltora, inflation linked bonds fund manager at AXA Investment Management, which oversees 607 billion euros of assets, referring to the possibility that a weaker currency would make European goods cheaper than those produced in Japan and elsewhere.” This is precisely what is going to happen, and what Europe NEEDS to happen to finally get out of this period of virtually no economic growth lately. The European Central Bank knows this and that is why (or atleast part of the reason why) the ECB announced a quantitative easing plan of bond buybacks. As Joseph Adinolfi writes in his article, Euro Records Largest Weekly Loss Since Septemeber 2011, “BK Asset Management’s Boris Schlossberg rhetorically asked if eurozone quantitative easing was intended to drive the euro even lower, arguing that ECB Executive Board member Bernard Coeure admitted as much during an appearance from Davos, Switzerland that was broadcast on CNBC Friday. “Taken from that perspective the ECBs actions make perfect sense,” Schlossberg said in a Friday morning research note. “The QE announcement has shaved another 300 points off the EUR/USD exchange rate and the pair is now fully 20% lower than just nine months ago.”” This will hopefully give the entire Eurozone the economic boost it needs to get back on track as an economic heavyweight!

How to evaluate investors in the era of government intervention

It’s becoming increasingly normal that government intervenes financial markets. On the last Thursday, the ECB finally joined the “QE club” and this announcement led higher stock price, lower interest rates and lower Euro, which is probably what the European policymakers wanted. While it’s tempting to just focus on macroeconomic impact of these intervention policy, one should not forget about an impact on investors’ behavior. In the ECB example, most of the discussions are about how QE policy works to get European countries out of economic stagnation, and only a few people seem interested in how the policy affects investors’ incentive.

Let’s say government intervenes particular market and the price of intervened asset keeps raising. While many investors think it’s might be a bubble, it’s not always the case that they sell that asset expecting their investment decision will be finally paid off when a bubble bursts. Why isn’t? One reason might be the fact that many investors are evaluated based on “excess return (alpha)”, not absolute return. In other words, they have to earn more than their benchmark (e.g. market indices of the asset class they invest) earns. This means that as long as the asset price keep raising, investors who go against the market keep making “loss” relative to their benchmark. And since their performance is often evaluated in short period of time, their best strategy to maximize their clients’ benefit could be just following the bull market, even if they know it’s a bubble.

There are two important implications drown by the example above. First, since some governments intentionally create market distortion based on their belief on how intervention can help to achieve their policy goal, we cannot just say “bubble is bad” in this era of government intervention. Second, when asset boom is going on, either buyer or seller of that asset is betting on their investment strategy, purely to maximize their profit just as they usually do. This also means that the investment strategy should be evaluated based on the investment performance, not from the “social welfare perspective”. Based on those arguments, I would disagree with the idea of “Betting against subprime mortgage loan was a good thing” in the recent blog post by Dean Baker.

As the recent episode of the Great Recession and aggressive policy response by the Fed and other US policymakers clearly depict, government intervention policy can help to achieve policy goals. However, it’s policymakers’ job to prevent excessive asset bubble driven by their policy. And we should evaluate investors by how much they earn, not by what they do for the society.