Monetary Policy Special

  • QE manual in 300 words
  • How would re-starting QE help today?
  • Pushing with a string and the fiscal equation
  • What would be different now?
  • Adding the inflation target debate to the mix

This Macrocast focuses on a single theme: monetary policy. It is probably unfair to ask from our readers who are currently dealing with a nasty heatwave to digest a fairly technical and theoretical foray into quantitative easing in the middle of the summer. But we think it is worth taking a bit of distance from the “will they/won’t they” approach to discussing the European Central Bank (ECB). Yes, the ECB will probably do “something” on top of a depo rate cut in September. We fear this “something” may well end up being a weaker form of quantitative easing than the market has been pricing for a while. But more fundamentally, what matters is whether another dollop of accommodation would work. We are concerned as we think we are reaching the limits of the European policy-mix.

The corporate sector has by and large failed to take advantage of quantitative easing (QE) to re-start growth – even if it has restored its financial health. We thus see QE now - especially when coupled with a symmetric inflation target - mostly as an instrument to try to force core countries into fiscal reflation. We note however that so far the “Draghi put”, with us since 2012, has not affected these governments’ fiscal planning, and we see little chance it changes quickly. In a nutshell, there is little point in a pre-emptive monetary policy if fiscal policy is not. This would be consistent with an unfavourable environment for investors, with ultra-low to negative interest rates for very long, and persistently mediocre growth prospects.


How QE works in 300 words

In theory, QE operates by forcing an injection of cash to the non-financial agents. This is why it works best when the usual transmission mechanisms of monetary policy are temporarily broken. Indeed, normally, providing cash to the non-financial agents is the job of the banks, which create money out of thin air by extending loans. But there may be circumstances in which they can’t or won’t do this job, for instance because their own capital position is compromised, regulatory pressure is forcing their balance sheet to shrink, or their assessment of the borrowers’ riskiness is so negative that they would refuse to lend at any economically sustainable interest rates.

In such configuration, allowing banks to access cheaper liquidity via the conventional operation of monetary policy is not going to help. Cash will remain within the financial sphere, staying idle in banks’ excess reserves at the central bank. By buying assets - any asset - from non-financial agents, with QE central banks by-pass commercial banks to provide a monetary stimulus directly.

In another approach, QE merely works by lowering interest rates across a broader range of assets, across the entirety of the yield curve. This works best when the central bank’s policy rate has hit the lower bound. QE then is the continuation of normal monetary policy by other means (lower interest rates across the board lift the economy back to potential by spurring investment and discouraging saving). The ECB probably provides the best natural experiment there: it engaged in QE once it had taken its policy rate into negative territory, then bought only the risk-free asset (government bonds), and when the drop in sovereign yields failed to take interest rates on other assets classes down quickly enough, it started buying corporate bonds.


How would re-starting QE today help?

There is no blatant sign, over the whole of the Euro area, that banks are currently restricting the supply of credit in a concerning way. The latest bank lending survey suggests credit standards are getting a bit tighter, but we are very far from the extremes seen in 2012 and banks were not expecting a continuation of this tightening into Q3 (Exhibits 1 and 2). Poor demand is the driver of the current mediocrity in credit origination.

Arguably though this would not be enough to dismiss QE now. What Exhibits 1 and 2 also suggest is that the Euro area was well past the peak in the tightening in credit standards when the ECB finally announced its bond buying programme at the end of 2014. This was not a decisive factor then. It might not be one now.

What is probably more problematic is that the “alternative channel” – lowering yields across the curve on all asset classes – has not had a very visible impact on the decisions of the corporate sector (Exhibit 3).

In the national accounts the net saving position is equal to profits (operating profits minus tax, net interest payments and dividends) minus physical investment. A negative net saving position entails a net borrowing requirement, which in theory is the default position of the business sector. That they transitorily turn into net lenders – i.e. that they save more than they invest – was understandable at the worst of the Great Recession in 2008-2009, as well as during the sovereign crisis of 2011-2012, given the level of uncertainty. What is less easy to understand is why they continued to accumulate saving once the “Draghi put” was in place and later when QE crushed funding costs.

Another layer of mystery lies in the new-found appetite of the corporate sector for cash holdings. So, not only are corporations increasing their saving effort in spite of ultra-low to negative funding costs, but they are accumulating a lot of those savings into cash, which itself provides zero to negative returns.

True, we don’t know what the counter-factual would be. It is possible that corporate spending would have been even lower without monetary policy accommodation, and at least the drop in corporate net interest payments has allowed businesses to maintain or improve their profitability without exerting more pressure on employment and wages. But for the time being, there is little evidence that ultra-low to negative interest rates have moved the Euro area as whole away from the domestic-demand rationing model which has been in place since 2010, consistent with a current account surplus and an unfortunate sensitivity to the global cycle exactly at the time when international trade is under threat.


“Pushing with a string” and the fiscal equation

This is why the ECB is increasingly explicit about the “fiscal solution”. Mario Draghi stated this Thursday that “if there were to be a significant worsening in the Eurozone economy, it's unquestionable that fiscal policy – a significant fiscal policy, mostly in some countries but also at the euro area level – becomes of the essence”. He could not have been much clearer.

A big issue though is that so far, European governments have not responded to the lure of low to negative interest rates to significantly alter their fiscal planning.

Using the European Commission data we break down in Exhibit 4 the fiscal position of the government for the Euro area as whole (“total deficit”) in three components: “discretionary” (the result of government decisions on tax and spending), interest payments and “cycle and one-offs” (mostly the impact of the business cycle on tax receipts). We then compare the actual outcome for these three components with what the European Commission was forecasting (what the EC was predicting in the autumn of year n for year n+2). We calculate the “average forecasting error” since 2012 and Mario Draghi’s “whatever it takes” speech.

What is striking is that the Commission has been right about the “discretionary” component. This is reassuring since the EC relies on the national governments’ own programmes. In other words, by and large, on average in the Euro area the governments have done what they said they would. However, the EC has in general been forecasting higher deficits, and this comes essentially from having constantly expected too high interest rates.

We can look at this from a different angle. The governments have not taken advantage of lower interest rates to “ease up” their discretionary stance.

We then focus on Germany, doing the same exercise but this time comparing the outcome for these fiscal components with Berlin’s own “Stability Programme” (Exhibit 5). What is striking there is that in the end the total deficit has been significantly lower than planned (actually in Germany’s special case the surplus has been significantly higher than planned) primarily because the discretionary component was doing better. In clear, while the economy was growing faster than expected and interest rates were (a bit) lower than planned, the government chose to raise its structural surplus.


What would be different now?

If German fiscal policy has not responded to negative yields so far, why would it now? Actually, since the mini-recession of late 2012-early 2013, the German economy has been doing rather well, amid generally normalizing external demand. There was then little reason to spend the interest rate and cyclical windfalls. This has changed now and the recent German dataflow has been very concerning. There is now a very good case to try to offset the lack of traction from foreign demand with a domestic push.

The noises from Berlin are not very encouraging though. German Finance Minister Olaf Scholz stated on TV just before Mario Draghi’s press conference that he has no plans to loosen the fiscal stance because “it’s not necessary or wise to act as if we were in a crisis”.

So, in clear fiscal policy there would be reactive, not pre-emptive. We suggested in Macrocast that stubbornly low export growth would end up hurting the German labour market, and presumably this could change the political equation there, but it is true that for now the signs are not blatant outside the manufacturing sector.


Adding the inflation target debate in the mix

An important move this week was the ECB’s change of tack towards a symmetric inflation target. We had mentioned this in last week’s Macrocast and in our view this would normally be consistent with a flatter curve, since it would telegraph more patience from the ECB to hike rates even once inflation has hit 2%.

The message the central bank is thus sending to the core countries is that rates could not only get lower – in their case more negative – but perhaps more importantly for longer. Implicitly, we think Draghi is proposing a bargain to these governments: consent to a fiscal push to shorten the phase of negative yields for their savers.

However, for the symmetric inflation target to be credible, the ECB needs to show that there is no technical/political limit to its policy capacity. And this is where we think the Council is not yet fully on board. Breaking the limits (33%, capital key) is a big issue we have covered several times in Macrocast. This means there is a fair chance the dollop of unconventional monetary policy the ECB could end up granting in September could be weak (i.e. “scrapping the barrel” on QE and pushing to, but not beyond, the current limits).

In any case, the “tete a tete” between the ECB and the fiscal authorities in the core countries could last quite long. Investors would then be faced with a quite adverse environment: with a “very patient” central bank and the supply of Bunds continuing to fall as Berlin would try to avoid a fiscal push for as long as possible, market rates would continue to fall.

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