Tuesday, December 1st, 2015

What the Fed and the ECB Want

We have arrived at that point in the quarter where everything is dominated by what the major central banks are going to do at their next meetings. This quarter, there is even more of a logjam than normal because the two major banks in the world are forecast to move in different directions. Lots of commentators have already written about the implications of this divergence. Our theme is different. We want to explore why the ECB will not be able to achieve what it wants and why the Fed doesn’t know what it wants.

First the Fed: we know it wants high employment in the US and inflation expectations at about 2% – i.e. world peace, motherhood and apple pie. The trouble is, it is unsure what variables it has to change and by how much in order to achieve these ends. There is confusion between objectives and policy. Apple pie is all very well, but you need a spoon to serve it with. This won’t stop the FOMC from raising rates next week, but it will be interesting to see how they argue the case. Short rates on their own have less effect on investment and employment than decisions by senior lending officers. Their impact on inflation expectations is also small – nothing in comparison with energy prices or the shape of the yield curve. If the Fed wants to move the long end of the curve it would have to commit to a much faster pace of tightening than it has forecast so far. It may just argue in favour of reversing the decline in the term premium, which would perfectly compatible with the current state of the US economy, but this is really outside its control. It is an international, not a domestic variable, which is where the ECB’s intentions come in.

The ECB wants the euro to depreciate and doesn’t seem to care which policy buttons it has to push in order to achieve this. Negative short rates and further bond-buying programmes should be enough. Unfortunately the larger objective – stable non-inflationary growth in the Eurozone may still be beyond reach. Banks don’t lend more money when interest rates go more negative; it’s a tax on their liquidity, which means they need to increase margins on their normal commercial loan books, especially if volumes are constrained by capital adequacy rules. Portfolio investors do not automatically buy domestic equities when the euro falls. Their first response is to chase a rising yield differential and a currency gain. The big story this year is the flow out of euro-denominated assets into the US dollar, not the performance of Eurozone equities. If the ECB wants the euro to go down, it will be very difficult for the Fed to engineer a material increase in the US term-premium – and the Fed knows this.

Unless the ECB announces something radical, we see no reason why this round of QE in Europe will have more effect than the last. Our preference would be to direct the ECB bond-buying programme at a new class of securitised non-performing bank loans, of the sort that the Italian government is trying to repackage now. The programme would not be confined to Italy, but Italy could be the testing-ground. There are all sorts of objections, but monetary policy won’t work while the transmission mechanism to the real economy is broken. Banks account of about 75% of all corporate borrowing in the Eurozone. It they don’t lend, it’s hard to see how companies can accelerate their investment plans. In the end something like Brady Bonds (Latin America in the late 1980’s) will be required to get the Eurozone economy moving again. Euro depreciation on its own is not enough.

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