On June 5, 2014 the European Central Bank’s (ECB) governing council unanimously voted to push its deposit rate into negative territory and lower its lending facility to a mere pittance. The cut in interest rates—including the negative deposit rate—were symbolic gestures. In fact, they won’t have any effect until November when banks pass through the asset quality review, and the moves may even need to be reversed.
On their own, these steps by the ECB were disappointing. In fact, they were grossly disappointing, as evidenced by the markets’ immediate reaction to the ECB’s statement.
Draghi to the rescue
But three quarters of an hour later, Mario Draghi stepped forward and unveiled additional policy measures which helped resuscitate the markets.
Draghi showed that he is no Trichet. During Jean-Claude Trichet’s tenure as ECB president from 2003-2011, he did a stellar job of keeping Eurozone inflation close to, but not quite at, 2%. That’s precisely what the ECB’s mandate is. However, his single-minded focus on inflation made him blind to problems he was sowing for the future.
Like the majority of monetary policymakers, Trichet’s views on inflation were too myopic.
Separating noise from signal
What Trichet and the ECB missed, or ignored, was that inflation isn’t caused by monetary expansion alone. In a modern economy it also requires credit expansion. Year-on-year, in April 2011, consumer credit contracted by 2.4%, and loans by eurozone banks to non-financial corporations with a maturity of 1 to 5 years contracted by 4.6%. Any pickup in monetary aggregates was driven by fear of the unknown, not excessive risk taking. Disinflationary pressures were building as banks shrunk their loan books relative to their capital, or tried to take on less credit risk rather than funding private sector activity.
Focusing on a one year-on-year number, or even a short series of year-on-year price increases, is overly myopic. 2011 numbers were distorted by increases in energy and food prices. Short-term noise was interpreted as a long-term signal. This is a matter of debate; hindsight is always 20-20. However, my criticism isn’t meant simply as an after-the-fact assessment. It’s about monetary policymakers holding onto a flawed theory of inflation.
Credit expansion strategy
Mario Draghi announced the creation of a Targeted Long Term Refinancing Operation (LTRO), designed to pump credit into the economy. By providing cheap four-year financing to banks, on the condition that the funds be used to expand credit, the eurozone banks can go from shrinking credit to more rapidly expanding it.
The ECB’s program specifically excludes mortgages and public debt from being financed; however, money is fungible, freeing up old money to finance mortgages and purchases of government securities when new money is raised. Still, whether in practice or just in theory, these provisions mitigate the perception that the ECB may be fueling a housing bubble—as the Bank of England has been accused of through its funding for lending scheme—or that it is monetizing government debt.
Because inflation is driven by credit expanding faster than the economy can absorb it, a 400 billion euro provision of liquidity to banks through the LTRO could push inflation up an additional 1.7 percentage points. While that would create headline inflation slightly above the ECB’s target of ~ 2%, that boost will likely be short-term, more like a kick-start to inflation rather than a permanent increase.
And this provides hope that perhaps the ECB and their image may improve under Draghi’s leadership. He appears to be less myopic than Trichet and able to see through the short-term noise.
The ECB is a bold actor
While Trichet seemed too timid in the face of temporary inflation that was actually just part of a disinflationary trend, Draghi has turned the ECB into a bold actor. The ECB may end up looking indecisive if it needs to reverse course on penalty rates on bank deposits. This could increase what’s called the “term premium,” or the difference between longer-term interest rates and short-term interest rates. The term premium is determined by many factors, but one of those factors is investor confidence in the stability and predictability of monetary policy going forward.
The effects of monetary policy often aren’t felt in the real economy for months or years after the fact. But it is at least the ECB is acting—and not counteracting— progress in cleaning out the plumbing of the eurozone’s financial system.
Brian Jacobsen, portfolio strategist, Wells Fargo Asset Management.