First posted on:
MarketWatch, 21 September 2018
ECB President Mario Draghi has declared that euro area economic growth is on a steady course and that the risk of deflation is fading, allowing the central bank to phase out its bond-purchase program by the end of December.
Such ‘mission accomplished’ rhetoric is entirely contrary to reality. In truth, the ECB’s bond-buying programme has largely failed – economic growth is slowing, and inflation remains worryingly low.
With the ECB reaching the political limits of its actions, perils lie ahead for the euro area economy.
At his 13 September press conference, Draghi insisted that the euro area economy is set to experience “broad-based expansion” and the inflation rate is on course to rise “gradually rise” from its worryingly low underlying (core) rate of 1% over the past three years. While he acknowledged that euro area economic growth had “moderated” since early 2018 after “strong growth performance” in 2017, he brushed aside the “moderation” as temporary.
This optimistic assessment has it backwards. In 2017, Chinese authorities made available easy credit to pump up their economy. That domestic growth acceleration, through China’s huge influence on global trade, caused growth in world trade to surge to nearly 5.5%. European economies rely heavily on international trade, and euro area economic growth recorded a temporary above-normal performance.
However, starting in early 2018, Chinese authorities began withdrawing the domestic stimulus for fear that the already dangerous financial risks could become unmanageable. World trade quickly slowed down to a pace of around 3.5%. The euro area economy slowed in tandem with world trade. As the Chinese deceleration continues, euro area GDP will continue to slow down from its unusual clip in 2017.
The ECB is underestimating the pace of slowdown. In December 2017, it projected that euro area GDP would increase in 2018 by 2.3%; it has now scaled down that forecast to 2.0%. However, parts of the euro area – Italy and even France – could face recessionary conditions in the coming months.
The ECB responds late and then only with half measures
On inflation, Draghi’s optimism is even more mystifying. Bond purchases did little to move the inflation rate. The core inflation rate – the rate stripped of volatile movements in energy and food prices – has remained stubbornly grounded at an annual 1%. Yet the ECB has remained faithful to its prediction that the inflation will rise soon.
Consistently low inflation is a problem because it creates the expectation that inflation will remain low, causing consumers to postpone purchases. GDP growth is held back; government and private debt burdens remain elevated.
Put simply, while the ECB’s bond purchases brought down interest rates, which helped reduce debt-service obligations, the programme proved largely ineffective in generating growth momentum or raising the inflation rate. The problem with the ECB since its start in 1999 is that it always responds late to economic weakness, and then only with half measures.
The contrast between the ECB and the Federal Reserve
This tendency proved especially costly after the onset of the global financial crisis in 2007, when the ECB remained ideologically committed to high interest rates to prevent a phantom inflation. Even after deflationary tendencies set in by mid-2013, the ECB inexcusably delayed the introduction of bond purchases to January 2015 while members of its Governing Council acrimoniously debated their competing national preferences in public.
The ECB’s actions stand in stark contrast to those of the US Federal Reserve, which, after rapidly reducing its policy interest rate to nearly zero, began its bond-purchase programme in December 2008 — three months after the collapse of Lehman Brothers. The Fed continued the bond purchases for nearly six years up to October 2014, at which point it could taper the purchases with some confidence that, temporary setbacks notwithstanding, the US economy was on a sustainable recovery path.
The ECB bond purchases, after their late start, were much larger than the Fed’s purchases, both in relation to GDP and net new government bond issuance. However, the ECB’s commitment was unclear. Already by October 2017, Draghi began to speculate about exiting from the programme. The ECB has now delivered on that exit promise before completing its task.
The consequences are stark. Over the past three years, despite tightening monetary policy in the US, the S&P 500 index has climbed nearly 50%; over the same period, despite ECB easing, the Euro Stoxx 50 is up less than 7%.
The ECB is stuck with the consequences of its delays, much like the Bank of Japan is. The Japanese economy fell into a low inflation trap in the 1990s because the BOJ repeatedly pulled back its monetary stimulus too early. Even after stepped-up bond purchases since January 2013, it has been unable to raise inflation.
The economist Paul Krugman has written that the BOJ’s past “timidity” has strengthened public expectations that inflation rates will remain low. So on average, Japanese businesses don’t raise their prices, which reinforces deflationary conditions. The BOJ, therefore, helplessly and ritualistically repeats that inflation will rise in the “medium term.”
The lesson of recent history is clear. The US Federal Reserve began early and aggressively fought the risk of excessively low inflation. US core inflation never fell too low, and the core inflation rate in the US is now close to the target 2% rate. The BOJ’s ongoing effort, plagued by the history of past half-measures, has achieved little by way of higher inflation.
Compared with the ECB, the BOJ has done modestly better. BOJ bond purchases have succeeded in somewhat lowering value of the yen against the dollaras well as against a basket of currencies, providing some support for Japanese economic growth. The ECB has been unable even to push down the euro’s value against the dollar. It remains around $1.17, almost exactly where it was at the start of bond purchases in January 2015; in fact, against a basket of currencies, the euro has appreciated.
Fresh tensions for Italy, Spain, and Portugal
Despite little to show for its effort, the ECB has declared victory because its governing mechanism, stymied by national conflicts, has reached its political limits. Continuing to accumulate bonds of member country governments runs the risk that when the purchases stop, interest rates will rise and, hence, the value of the purchased bonds will decline, possibly sharply.
The rise in interest rates (and loses on past bonds purchased) will likely be especially large for Italy, Spain, and Portugal, which could face something of an investor drought after the stoppage of bond purchases. Investors who have sold these countries’ government bonds to the ECB (and to the country’s national central banks) have used the sales proceeds to buy assets outside the countries. German interest rates, in contrast, will rise very little. The uneven distribution of financial and economic stresses will inevitably elevate political tensions.
The euro area is entering a perilous phase with no easy fix. Rising interest rates will further dampen growth and inflation. The eurozone’s debt and banking fault lines will re-emerge.
While Draghi has promised that the ECB will gear up its bond purchases again, divergent national interests will ensure delays and half measures. Divergence of national interests remain the euro area's tragic central flaw, its Achilles’ heel.