The last few days have seen media outlets rush to predict a change in monetary policy from the European Central Bank this week. This left them around a fortnight behind the hints that the ECB has been giving! However much more reticence has been shown around the subject of what it will do with reports invariably confining themselves to outlining the options. In terms of market expectations they have clustered around a small interest-rate cut possibly of the order of 0.1%. As this would take the ECB into the world of negative interest-rates we could define this as being like a swimmer edging fearfully up to a swimming pool and dipping only his or her small toe into it. There is also the conceptual issue of exactly what impact a cut of this size would have? After all we saw cuts totalling 0.5% in 2013 and have seen 4% in total for the main refinancing interest-rate. So the logic apparently is that as it has not worked -otherwise why are we even discussing this? – a move of one fortieth of its size will!
What is the problem?
The issue here has got muddier as the Euro area has returned to growth but seems only to be edging forwards. For example yesterday’s business survey for manufacturing told us this.
Eurozone manufacturing recovery slows as France falls back into contraction and growth eases in Germany, Italy, Austria and Greece.
The spot reading of 52.2 in May was below that of the 53.4 for April hinting at a reducing rate of growth for manufacturing. However for the economy overall the business surveys remained optimistic.
the decline still leaves the manufacturing economy growing at a quarterly pace of approximately 0.5% in May.
Whilst we do not get the latest services report until tomorrow the flash data at the end of last month was positive leading to this forecast.
Taken together, the PMI surveys are pointing to a second quarter GDP increase of approximately 0.5%.
This would be the best performance for three years and on its own does not make much of a case for further monetary expansion and easing. There is however a cautionary note which is that for the first quarter of 2014 the business surveys predicted economic growth of 0.4% and we got 0.2% instead. But the case for moving on these grounds to my mind is if anything along the lines of the famous question from Muhammed Ali to George Foreman.
Is that all you have got George?
There are regional issues such as the stagnation being seen in France but as the ECB looks in its toolbox there is not much if anything there which would help.
Here is the area where the media has concentrated its fire and to be fair some support for their arguments arrived at the beating heart of the Euro yesterday. From Destatis
The harmonised consumer price index for Germany, which is calculated for European purposes, is expected to increase by 0.6% in May 2014 on May 2013. Compared with April 2014, it is expected to be down 0.3%.
As various individual states had reported earlier, the shock effect was not what it might have been, but you can see that a move downwards in inflation in 28% of the Euro area economy is significant. Also there is the symbolic effect of even Germany edging nearer to zero inflation. Interestingly the main mover so far – energy prices – warned of and was replaced by, falls in both services inflation and food inflation suggesting that the disinflationary trend is now more widespread.
Accordingly I was waiting for this morning’s update for the whole Euro area and here it is.
Euro area annual inflation is expected to be 0.5% in May 2014, down from 0.7% in April , according to a flash estimate from Eurostat,
If we look into the detail we see a similar pattern to Germany where the disinflationary effect of energy prices has waned but been replaced by a more widespread disinflationary phase as highlighted below.
services is expected to have the highest annual rate in May (1.1%, compared with 1.6% in April), followed by food, alcohol & tobacco (0.1%, compared with 0.7% in April).
This is awkward for the ECB on two counts. Firstly it trumpted “special circumstances” earlier in the year whereas now we know that an 0.5% annual inflation rate was not that special as it has now happened twice. Secondly its forecasts were very different to this.
@econhedge To remind, 3months ago ECB forecast inflation would be at 1.0% in current quarter. Per May stats, it’s running at half that level.
So the ECB finds itself now in an analagous position to the boy who cried wolf as there is a limit to its ability to use the ‘special conditions’ excuse again. This is reinforced by the fact that disinflation was evident in all sectors in May. Somewhat ironically even the favourite stand-by of central bankers the “core” inflation rate fell even faster -from an annual rate of 1% to 0.7%- so I doubt it will be unveiled as an excuse any time soon.
So the media and analyst cavalry will be besieging the ECB towers in Frankfurt between now and lunchtime on Thursday when it announces the results of its deliberations. They will be hollering for action but in my opinion some care is needed. For example, if we look at the food category do they want to pay more for their food?Would they prefer to go back to May last year when food inflation was 3.2%? This is what, if you think of it logically, they are demanding. If we return to Germany as an example and jumped back in time via Dr.Who’s TARDIS we will see plenty of examples of low inflation combined with economic growth as being something to aim for and a type of economic nirvana.
An example of the likely media storm has arrived already from FastFT.
Why the ECB has to act
The Misery Index
It used to be the case that arguments for economic policy action were based on the so-called Misery Index where the annual inflation rate was added to the unemployment rate. It has fallen into relative disuse presumably around the time low inflation metamorphosed from a good thing into a bad thing! Actually the Misery Index would be falling on both counts right now.
The euro area (EA18) seasonally-adjusted unemployment rate was 11.7% in April 2014, down from 11.8% in March 20144 , and from 12.0% in April 2013.
So unemployment is falling overall but remains high. Accordingly the case for further monetary action here is based upon the hope that it would help unemployment fall more quickly.
If you look at the current situation then the Euro economy is seeing a weak recovery with low inflation. Therefore the issue is that it would like growth to be faster and here we see the rub as Shakespeare would put it. Expansionary monetary policy into a recovery, how does that work? We seem always to be in the words of Carly Simon “Coming Around Again” to an answer which is the same whatever the circumstances.
Proponents of such policies to my mind are asking the wrong question. A bit like in the book Bright Shining Lie when the military strategist John Paul Vann asked if the application of explosives was the right answer to the problems of Vietnam in the 1960s? The logical conclusion to their thoughts of fear about deflation is that the Euro area recovery will fade and die and that this period will be looked back on as a small up-tick in an ongoing depression. Here on the next leg downwards inflation could and indeed probably would push into negative territory.
The fly in their ointment is that the proposed solutions do not match up with such a problem. Perhaps the silliest is that a 0.1% interest-rate cut would do much if anything. But other moves such as Quantitative Easing also have the problem that if the future is not bright and is instead dark then kicking the can into the future is the wrong thing to do. Copying the Funding for Lending Scheme of the Bank of England has the catch that as I pointed out only yesterday UK business lending is even falling in the current boom.
I have argued before that the ECB is being treated unfairly right now. Yes it has made mistakes as, for example, if it was going to act it should have been at the turn of the year as I argued on this blog back then. For example it could have acted to offset the fall in the size of its balance sheet which is now heading towards one trillion Euros. Monetary policy has considerable lags in it so to be effective it needs to get ahead of events not chase them. However the real issue is one of reform and change and this is a job for Europe’s politicians who have signally failed so far. In a derogation of duty, in rugby terms, they have given the ECB a hospital pass – in terms all English rugby fans will understand right now – with a baying All-Black pack less than a step away.
The one area where the ECB could make a genuine move is to get the exchange rate of the Euro lower. Actually it has been trying this via “open mouth operations” for a while now but whilst the Euro has fallen to around 1.36 versus the US Dollar it has been only a small move. Like many central banks it finds that the most effective policy option it has is one which it has influence over but does not directly control. Also in an era where the Bank of Japan is trying to push the Yen lower and the rise of the Chinese Yuan has morphed into a decline we are left with an image of the competitive devaluations of the Great Depression. How did that work out?