Spain, The ECB And The Power Of Talk

Mar 30 2014, 1:01pm CDT | by

Spain, The ECB And The Power Of Talk
Photo Credit: Forbes Business

Spain is in a mess. Over a quarter of its adult workforce is unemployed, and according to CIB Natixis it has lost 25% of its production, even more than Greece. Spain’s inflation rate has been falling steadily and has now turned negative: the most recent retail sales figures show a fall of 0.2%. Various people anticipate ECB easing monetary policy because of the growing threat of deflation in Spain.

But this is to misunderstand the role of monetary policy in a currency union. The ECB sets monetary policy for the union as a single unit, not for its individual components. Deflation in Spain is a driver of ECB decisions only to the extent that it depresses Euro zone CPI. And I’m sorry if this sounds brutal, but Spanish unemployment is of no consequence, since the ECB does not have a mandate to target unemployment even at the Euro zone level, let alone in an individual country. The ECB can no more set policy to tackle deflation or unemployment in Spain than it can set policy to meet the desire of German savers for better returns. Its mandate is to maintain inflation close to 2% across the Euro zone economy AS A WHOLE.

Admittedly, Euro zone aggregates don’t look particularly healthy: inflation at 0.8% is far below the 2% target and M3 is stagnating. M3 lending is actually falling, indicating that bank deleveraging continues to place severe restrictions on the availability of finance, especially in periphery countries:

Real interest rates in the periphery remain far above the ECB’s policy rate.

But there is some good news, too. Euro zone stocks have risen substantially in the last week, and yields on periphery bonds are at their lowest for several years. And the Euro has fallen, which benefits exporters. To be sure, the Euro zone already has a trade surplus, largely due to the ever-growing German trade surplus. But exports need to strengthen in periphery countries too, so a falling Euro is perhaps good news for them (although I have argued elsewhere that it is more likely to benefit German exporters).

These market movements do not seem to be driven by fundamentals. Rather, they appear to be driven by expectations that the ECB will undertake more aggressive monetary easing, perhaps by means of QE or negative interest rates on bank reserves. The ECB has signaled that it is considering both of these.

But I fear these expectations are wrong. Signals don’t necessarily equate to action, and if markets respond to the signal by pricing in the action, then they may render the action itself unnecessary. If the ECB’s intention was to force a fall in the Euro, then the combination of signalling with the deplorable Spanish retail figures just released has already done the job. In which case there will be no easing.

My negative view of the likelihood of ECB easing is supported by this chart showing the ECB’s medium-term inflation forecast:

It seems that the ECB is expecting a sustained rise in inflation to start any time soon, gradually returning inflation to target by 2020. While this seems a long time, it should be remembered that many EU countries are undertaking structural reforms which can be expected to depress growth for quite some time to come. Greece has now been in recession for six years and growth has not yet returned.

In my view the ECB’s inflation forecast – despite the slow return to target – is over-optimistic. But it is not my view that matters. The question is whether the ECB believes its own forecast. If it does, there will be no easing.

The ECB’s optimism may be due to the fact that Eurozone banks are currently undergoing the Asset Quality Review, the Eurozone’s equivalent of the Fed’s recent stress tests. The AQR started in November 2013 and is scheduled to take a year to complete. Many European banks have over-risky balance sheets and insufficient capital: the AQR forces them to address this, not least because banks that fail the AQR may be wound up (it’s amazing what effect the threat of dissolution has!). This was the underlying reason for the horrible figures recently released by the Italian bank Unicredit. I have no doubt there will be other banks releasing horrible figures in due course.

If the principal cause of the fall in M3 lending is accelerated bank deleveraging due to the AQR, then it is reasonable to suppose that once the AQR is completed, those banks that are judged healthy will be in a position to resume lending to households and businesses. If so, then the credit crunch and associated disinflationary trend is a short-term phenomenon which will resolve itself in due course without any need for ECB monetary easing. Hence the ECB forecast.

The one thing that might make the ECB act would be the threat of Spanish default and the possibility of a run on Spanish banks. Spanish bond yields are low, but it is still struggling to reduce its deficit, a task that becomes ever harder as poor economic performance squeezes tax revenues. If Spain went into a prolonged period of deflation, risk of default would become significantly higher: this would force up bond yields and encourage investors to remove capital from the country’s banks. But we aren’t in this situation yet, and indeed we may never be: the upturn in inflation forecast by the ECB at the aggregate level seems to suggest they are not anticipating significant deflation in any country other than Greece.

So, putting all of this together, I do not expect the ECB to do any significant easing at the moment. But that doesn’t mean they won’t continue to talk about it. After all, signalling has worked well so far. Remember Mario Draghi’s promise to do “whatever it takes”? The ECB’s OMT sovereign bond support facility has never been used, but yields have stayed low ever since it was announced. Sometimes all a central bank needs to do is talk.

Source: Forbes Business

 
 
 

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