ECB and Inflation

[Iormlund]

What exactly has the ECB done then?

Absolutely nothing.

[Sheilbh]

What exactly has the ECB done then?

Announced that OMT is an option and said they'll do 'whatever it takes' to save the Euro. Unless we're in a brave new age of performative central banking they're not monetising anything.

Which is the problem. In a context of rigid monetary policy, austerity and private sector deleveraging it's no mystery why Europe's on the edge of deflation (with perilous consequences for deficits and debts).

[The Minsky Moment]

Even if carried out, OMT would not be debt monetization.  OMT is limited to buying bonds in the secondary market.  The debt is already issued and financed.  So OMT is basically just a garden variety open market operation, except targeted to certain bonds.  The Fed has been doing that sort of thing for a while now.

The Euro area has now had a full year of inflation below 0.5%.  If there really was concern about indebtedness - either public or private - you would think this would be a priority. 

[crazy canuck]

My only question is, when interest rates hit ten or fifteen percent, can they keep doing the same thing?

When do you think we will see interest rates of 10 to 15 percent?

[citizen k]

Submitted by Ben Hunt of Epsilon Theory

Here We Go Again

From an Epsilon Theory perspective, the scariest, most market risk-creating event of the past 48 hours had nothing to do with Iraq, nothing to do with Israel, nothing to do Russia. It was Mario Draghi's press conference.

Yesterday Draghi re-launched the Great Fiscal Consolidation War of 2012, a multi-level game where the ECB attempts to force spendthrift sovereigns to undertake structural reforms while ostensibly going about their business of maintaining their single mandate of price stability. It's a neat trick if you can pull it off, as Draghi kinda sorta did with the PIIGS two summers ago, but ... geez, do we really have to go through this all over again?

Multi-level games live at the intersection of politics and economics. I wrote about them earlier this year in the Epsilon Theory note "The Play's the Thing", and the basic idea is that public communication policy has a recursive, strategic nature. That is, while there's an ostensible meaning and an ostensible audience for any performance, there are almost always one or more deeper levels of real meaning and real audience for any political performance. And Mario Draghi is one heck of a political performer.

The press conference delivered two ostensible messages yesterday.

First, Draghi called out Italy and France. Why is Italian GDP back in the red? Why is France threatened by deflation, the Great Satan of modern monetary policy dogma? "It's mostly the lack of structural reforms", something "that has nothing to do with monetary policy".

Second, Draghi put the kibosh on monetary easing beyond what was announced months ago. Why not do more to force credit into the European economy? "If one can't open a new business [because of structural impediments], there's no point in giving more credit. You won't know what to do with this."

The linkage of the messages is the real communication here. Memo to France and Italy: you want more easy money? Then stop spending so much and pass meaningful labor and tax reform legislation. It's a giant game of Chicken, just like in 2012, and the big question now is who will blink first, ECB/Germany or Italy/France.

What do I think is going on? Why do I think that Draghi felt compelled to pull this stunt now?

I think that the looming conflict with Russia is a big problem for the German economy, which means that Germany's degrees of freedom to accommodate bad actors in the EU club are dramatically reduced, which means that Germany's overwhelming macroeconomic focus – a weaker euro and fiscal consolidation in the periphery (and France) – is now Draghi's overwhelming macroeconomic focus.

I think that the ECB's asset quality review and stress test of major EU banks has revealed just what a bitter pill it's going to be to assume regulatory control (see "The Red King" for more). Does anyone else find it odd that Espirito Santo, which has been under troika supervision for years, is only now revealed as a basket case, right before the ECB becomes its primary regulator? Sorry, but it seems like a kitchen-sink quarterly earnings announcement to me, where new management comes in and blames everything on the prior gang of incompetents. The last thing in the world these undercapitalized, overlevered, and stuffed-to-the-gills-with-sovereign-debt banks need is more pressure to finance their sovereigns, but that's exactly what they will face without structural reform and fiscal consolidation.

I also think that Draghi believes he's mastered the Common Knowledge Game, that he is confident he can always save the day if markets get too squirrelly by invoking the magic spell of the OMT or some other phantom policy. The difference between 2014 and 2012 is that Draghi believes he has established a safety net of sorts, at least to prevent a sovereign-level liquidity crisis as in 2012, with his command and control of the Narrative.

And trust me, the Narrative of Central Bank Omnipotence is alive and well. Want to read a really terrifying article? Take a look at this August 6th Op-Ed piece in the FT by Draghi's former colleague, Lorenzo Bini Smaghi: "The ECB Must Move to Counteract Market Turbulence". Are you kidding me? This is what we have come to ... that the proper role of a central bank is to counteract "market turbulence" before it happens? I'd laugh, but then I remember that Yellen means exactly the same thing when she refers to "macroprudential policy", and I want to cry.

Draghi is playing a variation on this theme. He's intentionally injecting "market turbulence" in order to achieve larger political goals, but only because he is of one mind with Bini Smaghi and Yellen and the rest of the Central Banking nomenklatura – central banks can control market outcomes. Period, end of story. And so far he's been absolutely right. Will the winning streak continue? I have no idea.

What I am certain of, however, is that this is a very dangerous game. It's obviously a disaster if the game spirals out of Draghi's control, if he's unable to put the inevitable market freak-out genie back in the bottle as he was in the summer of 2012. But it's a different kind of disaster, at least to my way of thinking, if Draghi succeeds, because then the Narrative of Central Bank Omnipotence will just be stronger than ever. If you like the notion of capital markets transformed into public utilities, then this is great news. For everyone else, not so much.

[Admiral Yi]

I'm having a little trouble getting my head around this concept that other than Draghi's statement about doing whatever it takes, the ECB has done nothing at all, and that has been all it takes to drive down periphery bond yields.

[Siege]

I woll read this threads tommmorrow. I rpromise.
Nothing good comes out off keynesisan thinking.

[Iormlund]

I'm having a little trouble getting my head around this concept that other than Draghi's statement about doing whatever it takes, the ECB has done nothing at all, and that has been all it takes to drive down periphery bond yields.

I would say it has to do with currency convertibility risk (but I'm not an economist).

Until the late summer of 2012 investors were worried about the periphery abandoning the Euro. This affected bonds directly but also lead to, for example, multinationals putting investments on their local plants in stand-by (something I saw regularly). This economy-wide lack of funding in turn worsened the economy, creating a perverse feedback loop.

When the ECB finally decided to overstep its mandate and announced OMT this risk was deemed gone. Without the spectre of a forced conversion to New Pesetas bonds were instantly more attractive and projects for which money had been withheld resumed slowly. For example, I'm leaving today to work for a couple months in an car factory not far from here, where my employer has been carrying out retrofits non-stop for the last year and a half - or in other words, working on delayed projects that were finally launched not long after Draghi's intervention.

[Sheilbh]

I'm having a little trouble getting my head around this concept that other than Draghi's statement about doing whatever it takes, the ECB has done nothing at all, and that has been all it takes to drive down periphery bond yields.

He did announce OMT too.

Not only that but their debt has skyrocketed in the last couple of years and the deficits aren't much lower. This is what I mean by it being about confidence. It was never about debt, but the Euro.

As I say I don't think it's gone away yet. If OMT is illegal or, say, Italy got in trouble the panic could return. I still think the Eurozone's some way from the scale of integration they need.

[Admiral Yi]

This is what I mean by it being about confidence.

I don't know what you mean by this.

[The Minsky Moment]

I'm having a little trouble getting my head around this concept that other than Draghi's statement about doing whatever it takes, the ECB has done nothing at all, and that has been all it takes to drive down periphery bond yields.

Just translate "Don't fight the Fed" into French, German, Italian, Spanish, etc.
It wasn't just those three words by themselves, but just those three words had big impact.
Now imagine if the ECB really had the full powers of the Fed, had a two-way mandate, and/or wasn't checked by Bundesbank retreads and Euro-constitutional lawyers.

[Admiral Yi]

Because if you do, then what?

[celedhring]

According to official data, we hit -0,3% inflation this past month. Woot!

[crazy canuck]

According to official data, we hit -0,3% inflation this past month. Woot!

See, austerity works - if the goal is to reduce inflation.   

[Martinus]

Poland has also experienced deflation, probably for the first time in recorded history, and we were not doing much austerity. Kinda begin to get scared now.