At the end of last week I discussed a scenario for the UK where a further base rate cut could be enacted by the Bank of England. This view is entertwined with my view on Europe’s prospects in 2014 and in particular for the Euro area. The European Central Bank will have retired for the Christmas and New Year break with thoughts of what to do next echoing in the minds of its Governing Council. The latter part of 2013 was supposed to be one where the theme was to be economic recovery. Instead the recovery was patchy and the themes were of disinflation and economic divergence at the heart of the Euro project as Germany stretched even further away from France.
But you do not have to take my word for it as in an interview with Der Spiegel published today the President of the ECB Mario Draghi told us this.
At the moment we see no need for immediate action.
Those who believe that you should never believe anything until it is officially denied will find plenty to chew on there! Also you may note the qualifications of “at the moment” and “immediate”…
Another public relations weapon deployed at a time like this is to declare that you are not as bad as some other nation who is set up as a pariah and Mario did not disappoint.
We don’t have Japanese conditions. There, the expectation of falling prices became entrenched. In the euro area, market participants are convinced that inflation will rise to close but below 2% again. In addition, Japan for a long time did not respond so resolutely in terms of its monetary policy as did the ECB. And finally, banks and companies in Japan were in a worse condition than those in the euro area today.
Monetary tightening in the Euro area
This may seem a strange paragraph heading for an area which saw official interest-rates cut to 0.25% in November. However other factors are at play just like in the UK. The similar factor is a strengthening exchange rate as the Euro continues to be treated as a type of Deutschmark-light. Since its recent nadir of 94.5 on a trade weighted basis in July 2012 it has been on an upwards path and reached 104.35 on Friday. The accompanying rise from nearly 1.20 versus the US Dollar to 1.38 on Friday has had an anti-inflationary effect which normally would be welcomed warmly but currently is helping to feed fears of outright price falls spreading beyond Greece and Cyprus.
Also the balance sheet of the ECB has been shrinking as banks have repaid the proceeds of the two LTROs (Long-Term Repayment Operations). Accordingly its balance sheet has shrunk from 3.01 trillion Euros at Christmas 2012 to 2.29 trillion now. This has been something of an own-goal driven by this referred to also by Mario.
we will be closely examining the balance sheets of banks in the coming year. No conclusive judgement can be reached prior to that.
The banks have reached something of their own judgement as they have pared down their position and exposure. This repeats the failures of the UK when “experts” like Lord Turner failed to realise the logical consequences of their actions. Thus monetary loosening has been put into reverse gear by the same organisation which is supposed to be leading the loosening!
The peripheral Euro area nations
These have a particular problem from the two areas of monetary tightening. Firstly via reform they are supposed to be examples of “internal competitiveness” improving but they are finding that progress in this area is having to run uphill as the value of the Euro rises or “external competitiveness” worsens. If we look at the Euro rally since July 2012 then the overall picture must be one of declining price-competitiveness.
Also these are the countries with the weakest banks and so any monetary tightening from stronger financial conditions imposed by the ECB will hit them the hardest. Today has seen a symbolic move on the front as the troubles at the world’s oldest bank Monte Paschi in Italy mean that the largest shareholder has voted to delay a cash call. Those wondering about the background to this can find it back on my post on January 28th. But the fundamental issue here is that banks facing capital and regulatory pressure are unlikely to be keen to lend and those under the severest pressure are mostly to be found in the periphery.
Inflation and disinflation
The disinflationary pressure of late 2013 was driven at least in part by the strong Euro and the shock effect of the 0.7% reading for consumer inflation in October was strong. Actually readers of this blog will not have been shocked at all but the media are now on the ECB’s case. There was some relief in inflation rising in November to an annual rate of 0.9% but there are two major problems for the ECB ahead in 2014.
1. Inflation below target-and looking likely to remain so- adds to the pressure to ease policy further.
2. Actual disinflation or falling prices is occuring in places where the debt burden is worst of all. For example Greece has the worst debt burden of 170% of economic output (and rising) whilst consumer prices and the GDP deflator are falling. The fact that wages and economic output are falling too makes this situation extremely toxic as another haircut or default looks inevitable. On every measure it looks less and less affordable.
But whilst there is some ennui about the situation in Greece -not shared here- there can be none about Italy. Previously Italy was a nation with a high public debt but with controlled annual deficits whereas now it has deficits which means that the debt is growing. As of the halfway point of 2013 it was at 133.3% of GDP and just as significantly it had risen from 125.6% a year earlier. In short unless Italy completely turns around and finds some decent economic growth the debate in 2014 will turn to a debt haircut there especially if these numbers from today spread throughout her economy.
In November 2013 the total producer price index decreased by 0.1 with respect to the previous month; the index of producer prices decreased by 0.1 on domestic market and marks no variation on non-domestic market……The index decreased by 1.8% compared with November 2012 (-2.3% on domestic market and -0.4% on non-domestic market).
On such a road one starts to wonder if the recent rise in Value Added Tax (a sales tax) was as much to nudge consumer inflation higher as to provide extra revenue. Of course however you spin it such moves are the last thing an already weak economy needs. So this year the saying that all roads lead to Rome might be particularly apt for the Euro area.
What next for the ECB?
It has a genuinely difficult problem and I have pointed out before that much of it has been caused by politicians sticking their head in the sand and leaving all the economic heavy lifting to it. Unless it is willing to be the first major central bank to take interest-rates into negative territory then that game is mostly over so it is left with its balance sheet and its currency. As it happens they are interlinked as recently the economic theory has been working as those easing the most -Japan- have seen their currency plummet whilst the ECB with a shrinking balance sheet has seen the Euro rise. I have pointed out before that the Germanic view will be to smile at this and the rest of us will mull the accuracy of this from Mario Draghi.
We run monetary policy for the entire euro area, not for a single country.
Right now the nation it most suits is Germany (again).
The rest will be debating how to expand rather than contract the ECB’s balance sheet. To reduce the value of the currency they will have to expand it substantially which will struggle to gain agreement. The catch is that “doing whatever it takes” has had quite a different response in the financial world to the real economy as highlighted below. From Bloomberg on Friday.
German stocks climbed, sending the benchmark DAX Index to a record……The DAX increased 0.8 percent to 9,562.55 at 10:20 a.m. in Frankfurt….The measure has rallied 26 percent so far this year.
Meanwhile in the real economy.
GDP rose by 0.1% in the euro area during the third quarter of 2013……Compared with the same quarter of the previous year, seasonally adjusted GDP fell by 0.4% in the euro area.
So far the recovery in the real economy of the Euro area has disappointed overall. There have been some brighter patches such as Germany and the balance of trade performance of Spain. But there have been disappointments in France -despite official optimism- in and Italy. Indeed the issues in France have been highlighted by this news today. From endgadget.
To the surprise of virtually everyone in France, the government has just passed a law requiring car services like Uber to wait 15 minutes before picking up passengers.
Overall the Euro area goes into 2014 with a little economic momentum but it is patchy and also reminds everyone of the divergence between its constituent nations. Its central bank is likely to step in again to try to push the economy forwards but where is real progress going to come from and what will happen if it the recovery stalls?
Rather ironically the ECB may be hoping for an oil price or commodity price rise……
Also I have two final thoughts for you. We will soon be finding out the price elasticity for Euro area exports to Japan as we observe an exchange rate which has reached 145 Yen. Also whilst I do not think we are there yet there are scenarios for 2014 where the ECB does take the plunge into negative interest-rates.