Quantitative Easing at the ECB - Not Yet in the Playbook
The following is a joint effort by me and Edward Hugh and if we are both individually prone to writing long and (sometimes excessively) winding entries a combination is bound to be long and ugly; well, the former at least. Surely, it seems, in Macro Man's words that the ECB may have had one of those Damascene moment as interest rates were cut by 50 basis points yesterday. It was not the actual 50 point cut which was largely expected, but rather the ensuing comments by Trichet. In particularl I took note of the fact that now it is not only falling energy prices (disinflation) being mentioned, but also downward pressure on prices from falling domestic activity.
Obviously, the discussion which we hope to initiate here comes in two phases. First, there is the question of whether or not the ECB should be considering QE at all? I am sure that there is plenty of people out there disagreeing with the sentiments expressed below. Secondly, there is then the issue of how exactly the ECB would conduct QE. Once again, I should warn you; this is a bugger and, at times, also somewhat technical.
Most sports coaches - irrespective of whether they work in soccer, baseball, rugby or even American football - have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.
So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone's "fluid and evolving" economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after....as Bank President Trichet said after today's decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?
But before we get ahead of ourselves, let's go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.
The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe's banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.
This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frankfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.
Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.
The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).
- In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.
- Secondly the crisis has now very much become an economic and not simply a financial one. We won't belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe's direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself - the German economy.
- This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice - of the Eurozone and even the European Union - are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.
In order to address the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as "unconventional tools" on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of "in principle" and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.
Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.
However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This "conjuring of demons" seems to us to be soo terribly Japan in the 1990s-ish.
In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and "everything under control". Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the "horrifying fact" that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.
This view was reiterated some weeks later by Luxembourg's representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the "usual suspects" - namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggressive monetary policy.
Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsoever. Such statements certainly constitute a starting point, but still perpetually create the feeling of "too little too late", and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.
This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing "zeitgeist" was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.
As BNP Paribas's senior economist in London, Ken Wattret, said at the time:
“We’re desperately spinning around to get a proper handle on the issue,” (...) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”
Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily be let to utter that famous "would the real spokesperson for the ECB now stand up"! The latest "dissenter" in the long line who have been queuing up to expound on their "nuanced view" was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made plain his opinion that:
The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.
That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us too much, since as Bloomberg reporter Ben Sils has pointed out, he is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week's outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. And don't for a minute believe Orphanides is merely doing a bit of headline grabbing. There is a real theoretical argument behind his position, one which he, himself, elaborates in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations towards inflation by "promising" very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry's IMF paper on the importance of communicating clearly when you want to make a "credible threat of irresponsibility").
What are Others Doing Then?
With the ECB being so cautious and unsure about whether or not to engage in what has now become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don't we take a look and see just what the rest of them are doing.
Morgan Stanley's Stephen Jen had a very useful piece on the Federal Reserves' entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collapsed into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the "lower bound") based on a division of labour between the bank (which has ballooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to "steer" inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.
- Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of "monetising" the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.
- The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).
- A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.
One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US' case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the "traditional" QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to "manage" the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.
So, What should and could the ECB do?
Well the answer to this question clearly depends on where you think the Eurozone's real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggressive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet's recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.
However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.
Ophèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.
Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.
This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.
However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:
We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.
Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can't deflate because households don't expect them to, and households don't expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don't get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.
As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.
Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European Union economy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.
Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB's own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?
But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce of the same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn't those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.
Time to Add More Pages to the Playbook?
We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an initial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe's present economic and financial crisis, and what kind of measures and tools we have available to deal with it.
Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today's, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by its peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs "originality" is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credibility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.