How Bundesbank and ECB will determine Europe’s economic future

10 Jan 2015 | Author: | One comment »

Central banks pass on opportunity to buy cheap euros.

Consumer prices fell by 0.1% in December, the first annual fall since a five-month stretch of deflation ending in October 2009, during the depths of the financial crisis.It seems like only yesterday that the Supreme Court was deciding Obamacare’s fate, Chris Christie was in political trouble for hugging someone, and investors were pushing U.S. borrowing costs under 2 percent as they sought a safe haven from the euro crisis.

The recent slowdown in economic activity across Europe will clearly serve as a catalyst for the governing council of the European Central Bank (ECB) to vote for a round of quantitative easing (QE).The total amount of reserves held in euros fell 8.1 percent in the third quarter, more than the currency’s 7.8 percent decline in the period against the dollar, according to the most recent figures from the International Monetary Fund. This vote may come with some dissent and the primary dissenter most likely will be ECB’s most-powerful member, Jens Weidmann, head of the German Bundesbank. The European statistics office said in a first estimate on Wednesday that prices in the 18 countries using the euro in December were 0.2 percent lower than a year before, after rising 0.3 percent in November.

Brent briefly slipped below $50 a barrel on Wednesday and few dealers are willing to call a bottom to the bear market in oil. “With oil prices falling markedly further to new lows and underlying price pressures still limited by weak economic activity, it looks ever more likely that the euro zone will see several months of deflation,” said Howard Archer, chief European and UK Economist at IHS Economics in London. While declining prices may sound like a good thing to cash-strapped consumers, deflation is usually a sign of deep-seated economic malaise, triggered by a paucity of demand. That was true two years ago, when it let a self-fulfilling panic almost push the crisis countries out of the euro, and it’s true today, when it’s let inflation fall so far that their already nonexistent recovery has stalled out even more. You’re not keeping a currency to lose money.” The ECB has experimented with negative interest rates on deposits in an attempt to draw money out of safe government debt and into the broader economy. Japan’s lost decade – which began in 1991, and has, arguably, extended to the present – speaks volumes about the difficulty in arresting a deflationary spiral.

Core inflation, which excludes volatile energy and food prices, was stable at an annual 0.7 percent in December — the same level as in November and October. Policymakers are signaling they are ready to step up the fight by expanding the money supply through further stimulus, such as purchasing government debt, that typically weigh on a currency’s value. Adding to the pressure is concern that Draghi won’t be able to hold the currency bloc together amid signs Greece may quit the euro area after its Jan. 25 election. These are, as the IMF points out, a continuum of the same problem: debts are harder to pay back and wages have a harder time adjusting whenever inflation is well below target, whether it’s 0.1 or -0.1 percent.

We expect another sharp fall in HICP inflation in January, by around -0.5 percent year-on-year,” said Gizem Kara, senior European economist at BNP Paribas. Since the euro’s 1999 launch, inflation has only once before fallen below zero, staying there for five months in 2009, although it has been in what the ECB calls the ‘danger zone’ below 1 percent since October 2013. Still, the now-tangible Ghost of Deflation Present has made investors more worried that Europe is stuck in a Japanese-style lost decade, but also more hopeful that this will finally force the ECB to do what it hasn’t wanted to: buy government bonds with newly-created money, aka quantitative easing. But Weidmann will fight against those purchases on the grounds of moral hazard and equate those actions to the notion of monetary financing which the ECB is technically prohibited to do. But December’s figure will leave the central bank “seriously concerned” that inflation expectations will weaken further, encouraging consumers to hold back purchases in the hope of even lower prices and so entrenching deflation.

ECB President Mario Draghi has taken to the media to make his case for a large-scale sovereign bond-buying program, offering a rather forceful public relations campaign to the German newspaper, Handelsblatt. German monetary authorities have made no secret of their distaste for quantitative easing, particularly any measures that would put the debt of southern European nations – read Greece – on the ECB’s balance sheet. That’s why investors are actually paying Germany to borrow money now—its two-year bond yields just hit an all-time low of -0.11 percent—and why borrowing costs across Europe are the lowest they’ve ever been. The decline in reserves allocated to the euro was more than four times the combined drop in holdings of yen, Swiss francs, pounds and Canadian and Australian dollars.

Buying private debt could end up being a surrogate for industrial policy depending on which specific sectors have the most amount of bonds outstanding, and this approach could end up having unintended consequences. Officials have recently said the ECB could require central banks in countries such as Greece or Portugal to set aside extra cash to cover potential losses from such bond-buying.

It hasn’t hurt that the rest of the world, whether it’s China slowing down, Russia imploding, or Japan dealing with a self-inflicted quasi-recession, is making the U.S. look like the only good place to park your money right now. This would leave the risk and cost of QE with individual countries, something critics say would undermine efforts to buoy the bloc, now 19-strong after Lithuania joined this month. The downside of rolling back austerity measures – a condition of international bailout funds – could look less frightening to voters if the ECB appears willing to provide a monetary backstop for the wider euro zone.

That wasn’t what was supposed to happen after the Federal Reserve started ramping down its bond-buying in late 2013, and growth eventually started ramping up. The most non-controversial form of QE for Europe will be one where the purchases of sovereign bonds are made across the Euro region on a GDP-weighted basis. These purchases will favour the larger economies of Germany and France rather than where the QE needs to be directed — Spain, Greece, Italy and Portugal. From an execution perspective, this may be an easier pill to swallow and a programme that may resonate with the Bundesbank chief, who will be most focused on potential law suits being filed in Germany’s constitutional courts as a result of this QE. The Washington-based IMF’s figures “suggest that there’s been genuine off-loading of euro reserves,” Alan Ruskin, global head of Group of 10 foreign exchange at Deutsche Bank in New York, said by phone Tuesday. “The share has dropped very steadily.

That’s not as good as it might sound, because long-term rates that are lower than they “should” be can, for example, inflate a housing bubble, like they did ten years ago. The early experiences of the US and Britain so far demonstrate that the cumulative QE programmes which have approached close to 25% of the GDP is what is needed to shore up growth without rekindling excessive inflation. Its problem, which, again, is really Europe’s, can also be summed up in a few words: it’s acted like Germany has a veto over, and not just a vote on, monetary policy.

With the Euro economy approaching $19 trillion in GDP, the ECB should be willing to look at a QE programme over the next five years, which could potentially be as large as $4 trillion. Having an ‘incentivebased’ QE where the ECB buys more bonds from the regions that embrace and execute long-term reforms readily could be one approach for getting the right behaviour from these countries. Any rift between them will result in a loss of confidence in the Euro, a test of the $/ exchange rate back to parity, a sharp decline in growth and equity prices in Europe which will filter its way to risk assets around the world.

Getting the two central bankers to be on the same wavelength will probably be the one of the most important items on Chancellor Merkel’s agenda for 2015.

Comments " How Bundesbank and ECB will determine Europe’s economic future"

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  1. Superb article. Lucidly written and a full exposition of the options available for the ECB. But this full article has been sliced down and the author is Guru Ramakrishnan, who is a brilliant financial mind. Why is the article not credited to the real author?

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