The ECB faces up to the prospect that Euro area monetary policy is “maxxed-out”

3rd June 2014 by Shaun Richards

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?

Economic growth

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.

A problem

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?



25 thoughts on “The ECB faces up to the prospect that Euro area monetary policy is “maxxed-out””

  1. Drf says:

    Surely the root of the low EU growth is excessive integral taxation? Yet over and over again the Beast wants still more, because its gross profligacy expands and escalates. The EU Commission has not had its accounts audited in any valid manner for I believe now over 10 years. Integral taxation is so high because EU corruption and waste is so high. As even Keynes acknowledged economies can be destroyed by wrong political actions, as we have seen so many times before in history.

    The Laffer curve effect is now well demonstrated, but politicians still will not learn. In any case, what is wrong with 0 percent inflation? That is what sound money is. Even “targetting” 2 % inflation is bad, since the cummulative effect is economically destructive. So, to achieve real growth what is necessary is lower integral taxation, not more debauchery.

    Low inflation can permit continued long-term low interest rates, giving sound money, and that really would stimulate economies.

    1. Anonymous says:

      The EC’s accounts are the least of it’s problems.

      The EC is a “rule” making body without the means of checking whether it’s rules are implemented and/or enforced. In some less law abiding parts of the EU, traffic police remind me of a quote from the book “Dangerous Places” by Fodors. “You can drive as fast as you like in Mexico, provided you have a ready supply of $20 notes”

      For all the United States faults, the FBI is a reasonably effective Federal law enforcement body. Under national vetoes, Stanishev and Berlusconi would VETO VETO VETO any move toward an accountable effective federal European police force.

      There is no accountability, and the EC demands for money will keep getting bigger.

      1. Drf says:

        Hi Expatin, I agree entirely with your comment; however, I would suggest that apart from the first sentence it does not seem to be an appropriate response to my original comment, since it almost entirely raises other issues which are unrelated, and would best have stood on its own as an independent comment, making extremely valid points which stand on their own merit.

        1. Anonymous says:

          Agreed. My comment is exclusively about the EC’s dysfunctional set up.

          I am surprised that the dysfunctional EC can maintain a strong currency. The markets treat EUR like DEM.
          Is this wise ?

          1. Drf says:

            Indeed, Expatin, I certainly agree; it is not wise that the markets treat the Euro as if it were the DEM in another guise, but I suspect that will soon come to a head?

          2. Anonymous says:

            Timescales are notoriously difficult to predict, but the results of deficits and inflation are depressingly easy to foresee

  2. Anonymous says:

    Hi Shaun,

    What exactly is the ECB supposed to do when politicians ignore the zombie banks and dead man walking governments ? (Eg countries like Greece that appear insolvent, but are forced to keep paying interest and maintain the pretense that all is well)

    Japan has tried supporting zombie banks for over 20 years. I wonder if the resulting financial woes have contributed to low birth rates and demographic decline. In Talking Head’s words this is the road to nowhere

    1. Anonymous says:

      Hi ExpatInBG

      The idea that this is a self-reinforcing downwards spiral unless reform and change happens has a lot of validity I think. Usually demographics gets the blame for being the cause but yes some may not have children due to their financial position and the noose tightens from the so-called effect too. A bit like Euro austerity and falling GDP isn’t it?

      I know it is a heretical idea for a central bank but the ECB could tell the truth.

  3. Pavlaki says:

    It puzzles me why the Euro hasn’t sunk further than it has when all of the warning lights are flashing red and the ECB try to talk it down. Maybe they need to hire Merv! Certainly the slightest hint from him sent sterling through the floor.

    I read about the Eurozone economies improving and yet the feedback I get contradicts the stats that are published. It could be that the growth is so anaemic that it doesn’t register ‘on the ground’ but only in official figures. The folk I talk to in Greece and Portugal are businessmen who belong to trade organisations and I am sure that they would hear of any improvement. They tell me that things are flat – at best, if not declining slowly. Not as quickly as before, but still no real improvement. Time will tell I guess!

    1. Anonymous says:

      Hi Pavlaki

      Thanks for the anecdotal evidence particularly about Portugal, it is time I sat down and took another good look at the state of play there. As to the Euro there was a worrying signal today as it strengthened against the major currencies in spite of the inflation news. If it is to be a case of buy the rumour and sell the fact this is going to be a long hard road for both the ECB and the Euro area economy.

  4. dutch says:

    Sober Look takes a view.

    ‘ Spanish 5-yr government bond yield is now below the 5-yr treasury
    yield. Real (inflation-adjusted) yields in Spain are of course still
    higher than in the US. But just to put things into perspective, almost
    exactly 2 years ago Spain was staring down a potential collapse of its
    banking system and was actively seeking bailout funds (see post).

    Once again, without a “show of force” from the ECB, this is not going to end well.’

    1. Anonymous says:

      Hi Dutch

      Yes and both yields are well below the UK 5 year Gilt which yields 1.93% and is an expensive point in the curve here. Markets have been pushing prices lower there and yields higher for a while. As to Spain it is all rather different to 5/6/7% is it not?

      But as you hint at much of this is due to promises from the ECB and how much of that/those is in the price? A lot I would suggest…

  5. Jim M. says:

    Hi Shaun,

    The economic outlook is too bleak for this poor, confused soul to even contemplate, but can we have Frank back now you’ve finished with him?

    1. Anonymous says:

      Hi Jim M

      I suspect that some of your fellow hammers fans foiled that prospect with the chants of “fat Frank” over the years. I guess I should be thanking them as it has been a pleasure to cheer him on and Chelsea will struggle to ever spend a better £11 million.

      I remember back in the time when I was in the trading pits that the Man Utd. fans would chant “Scholes get goals” and they were right that a double-digit return per season from midfield was high quality. But in goal terms Super Frank trumped that and my only regret is that he only rarely had the same impact for England.

  6. Anonymous says:

    Excellent column, Shaun, albeit depressing reading. The HICP without an owner-occupied housing component does not constitute a reliable measure of inflation, and I believe this is also the position of the ECB. If one excludes Ireland, which shows strong growth in house prices (6.3%; all figures four-quarter rates of change for 2013Q4), it seems that Greece (not available), Cyprus (-9.4%), Spain (-6.3%) and Portugal (-0.6%) have been undergoing deflation for some time. To my mind, any country with an HICP adjusted for OOH with an inflation rate below 0.5% is likely to have zero or negative inflation in reality, given the upward bias in inflation measurement. Martin Wolf of FT’s belief that an MUICP reading of 2% inflation is actually close to zero is clearly delusional, but the upward measurement bias may well be 0.5% or even slightly higher. So it seems that there is a problem with deflation in the euro area in Iberia and the Greek-speaking countries of the EU. Also the Netherlands (-4.5%), is probably also suffering from deflation once housing is added to the picture, largely due to the housing bubble that you have documented so well in your blogs.

    The ECB can’t run a regional monetary policy so it is not clear how they should proceed now. Arguably their existing low interest rates are creating housing bubbles in Estonia (15.6%), Latvia (7.9%), Ireland and Luxembourg (4.8%), so the ECB should be a little careful about running a looser monetary policy. Any one of these smaller euro area countries could be the next Netherlands. Andrew Baldwin

    1. Anonymous says:

      Hi Andrew

      You make a good point which intrigued me but the ECB data on house prices for the whole Euro area only reaches the end of 2013. We will have to wait until September to get a proper CPIH (H=Housing).

      Actually this reinforces a possible policy option for the ECB. I know that it has looked at the Funding for Lending Scheme of the Bank of England. It could do something similar and then feign surprise when it boosts property prices but is ineffective on business lending. The catch is the issue of lighting the property burners in Spain and Italy but as you point out there are 18 members.

  7. Andy Zarse says:

    A proposed 0.10% rate cut? Disappointed there was no reference to Newt from Aliens today Shaun!

    1. Anonymous says:

      Hi Andy

      You will not be falling off your chair as you read that I did indeed think of it! I found another one for potential use from that film.

      Ripley: Did IQs just drop sharply while I was away?

      Covers quite a few central bankers and politicians…

  8. shrimpers says:

    It is clear that tinkering with the headline interest rates will neither rejuvenate the economy nor remotely affect the outlook for dis- or de-flation – the die is cast, whilst millions are unemployed across the continent and millions more barely have the proverbial pot to p**s in, we are heading for another catastrophe, it is merely a matter of time.

    The ECB as part of the Troika and in cahoots with the global too big to fail banking fraternity and lickspittle politicians i.e. the elites, has enabled the destruction of the post war consensus, ensuring the rapid decline of living standards for the majority across the continent

    The ECB’s real justification for ‘forward guidance’, flooding the Eurosystem with more liquidity and/or adjusting rates is simply to reduce the overnight lending rate (Eonia), primarily to prevent the accompanying Euribor (benchmark term lending) levels from rising beyond where they were prior to the previous 2 rate cuts.

    All the LTROs/ABS/Covered Bond purchases being touted will only prolong the agony though, perhaps, as with QE/FfL/Abenomics witnessed elsewhere, asset prices will glean a further boost – you do not have to be a gambler to bet on tthe the chances of such action leading to enhanced futures for the 99.99% of people

    1. Anonymous says:

      Hi Shrimpers

      It is another form of can-kicking as opposed to actual reform and change of which there has been so little. Which is of course something which as you point out has suited the global elites.

  9. Noo 2 Economics says:

    Hallo Shaun,
    Things are looking amber for the EZ now but any ideas on the solution?

    Unfortunately, even though I said in apost a few days ago that open mouth operations had worked well for the ECB (meaning they averted a crash in bond markets and supported the Euro) they have now become a victim of their own success and I think the market knows there isn’t much they can do to devalue the Euro whereas they did have some tools re preventing a collapse in sovereign debt.

    The EZ continues to grow, albeit slowly even with a strong Euro – possibly a pointer to an economy much stronger than we think. Every one is obesessed with inflation and has forgotten the GDP growth story, probably because authorities are worried about both public and private debt financing.

    The threat now is of course future disinflation leading to deflation but how to turn it around? Devalue the Euro is the answer says the ECB but how can they talk down something they have been talking up and they have no tools (as far as I know) to devalue it, bearing in mind that they are now fighting against a recovering economy which isn’t lost on investors and maybe it doesn’t matter anyway if low growth is entrenched as long as it is a jobs related growth?

    1. Noo 2 Economics says:

      Sorry, just reread your comment para and realised you gave the answer but if they do what you say then:

      1. These are structural changes which will take a few years to manifest

      2. Won’t the result of these reforms be an ever strengthening Euro and how will that help them?

      I struggle to see what options any Euro organisation has to make changes that will lead to improvements in the immediate term, which is what they need right now.

      1. Anonymous says:

        Hi Noo2

        Yes structural reforms do take time which is why I have been arguing for them from the beginning. There would have been much more of a case for the type of actions central bankers have instituted if the time they bought had been used to cover the gap. Instead as you point out even if we start today it will be a while before the benefits arrive in force.

        If you wanted the ECB to add to it then it could intervene against the Euro, after all it has intervened to support it in the past! If the rumours are true the Belgians could do this by simply buying more US Treasury Bonds. In reality though there are much bigger fans of currency intervention than me and the danger would be of tat for tat moves from others.

  10. theyenguy says:

    You write, The one area where the ECB could make a genuine move is to get the exchange rate of the Euro lower.

    Please consider that the evidence suggests that the investor has been the centerpiece of world central bank monetary policies since 2008, this is seen in World Stocks, VT, Nation Investment, EFA, Global Financials, IXG, Eurozone Stocks, EZU, European Small Cap Dividend, DFE, and Energy Service, OIH, soaring in value.

    The whole purpose of the Euro, has been one of currency carry trade investing and debt trade investing. Mario Draghi’s LTROs and OMT, have benefited the investor and not the citizens of nation states within the Eurozone.

    It has been carry trade investor pursuing the EUR/JPY and debt trade investors buying European Credit, EU, that has driven the Euro, FXE, higher.

    So from the investor’s perspective the ECB has had it right all along.

    I fully expect to see competitive currency devaluation come on real strong as the Bond Vigilantes have gained and are exercising greater influence with the Bow of Economic Sovereignty, that is the Interest Rate on the US Ten Year Note, ^TNX, since May 2013, and are now calling it higher from 2.49%.

    The death of currencies commenced in May 2014, as is seen in Major World Currencies, DBV, such as the Euro, FXE, the British Pound Sterling, FXB, the Swiss Franc, FXF, and the Swedish Krona, FXS, trading lower; and the death of currencies, is accelerating in June 2014, with the Emerging Market Currencies, CEW, such as the Brazilian Real, BZF, trading lower. And, the failure of credit commenced in June of 2014, as is seen Aggregate Credit, AGG, trading lower.

    Credit Investments failed on June 2, 2014, as the Yen, FXY, traded lower on the failure of Abenomics; confirmation comes from Convertible Securities, CWB, trading lower, and Floating Rate Notes, FLOT, trading lower from its late May 2014 high. Investors no longer trust in the monetary policies of the world central to provide investment gains and stimulate global growth.

    The higher Benchmark Interest Rate ^TNX, put an end to risk-on investing, and thus stimulated Social Media, SOCL, Internet Retail, FDN, Nasdaq Internet, PNQI, Cloud Computing, SKYY, and the credit sensitive Small Cap Pure Growth, RZG, and the Small Cap Pure Value, RZV, to trade lower, and as a result, the US Small Cap Stocks, IWM, IWC, traded lower on June 2, 2014.
    Look for all Equity Investments to trade lower very soon.

    Economic deflation will come like a viper out of the failure of fiat money and fiat wealth.

    1. Anonymous says:

      Hi theyenguy

      How much lower do you see the exchange rate of the Euro going?

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