Draghi Speaketh

From: Erwan Mahé (guest post)

29 August 2014

Mr Draghi’s speech at the Jackson Hole symposium was definitely the highlight of late last week. A lot of ink has already been spent about it, and I preferred to wait a bit before expressing myself on the matter. I was especially waiting for the inevitable response of our German friends, who did not disappoint us, with German finance minister Schauble’s declaration this morning that the “ECB’s Draghi has been “over-interpreted.”

While I do not want to “over-interpret” anything our central bank chief says during his pilgrimages to the Grand Teton National Park, where the Siberian scenes of Rocky 4 were filmed, I think it important to understand it in full. After all, his comments appear just as significant as those made during his whatever it takes speech in the summer of 2012. The parallel appears all the more worthwhile, since I remember, the day before Mr Draghi pronounced his famous words, my own intervention at the same meeting to explain the ECB’s ability to reverse the situation before a gathering of American investors, terrorized as the European experiment appeared on the verge of collapse. My argument that no ECB chief would allow the eurozone to implode under his leadership was met a mix of scepticism and irony. Some Texas hedge fund managers bet on the zone’s implosion and claimed that the ECB’s efforts to oppose “free market forces” would meet the same fate as the BoE’s unsuccessful attempt to defend the pound sterling in 1992. Super Mario’s dramatic statement provided sweet revenge and some new diligent readers.

As you will see, below, aside from the monetary and fiscal implications of his speech, it is also the form that counts, as seen in the last minute changes in his speech! In addition to the substance of Mr Draghi’s comments, many observers were especially struck by the way they were delivered, given the discrepancies between the version of his speech distributed to journalists and the one later made available on the ECB’s web site! (A big thank you to Hugo Dixon for providing these items so quickly). Just consider this significant example. When Mr Draghi speaks of the recent decline in inflation expectations, the first version of his speech read:

“Acknowledging this [fall in inflation], the Governing Council would use also unconventional instruments to safeguard the firm anchoring of inflation expectations over the medium- to long -term.”

However, in the final version of his speech, Mr Draghi asserts:

“The Governing Council will acknowledge these developments and within its mandate will use all the available instruments needed to ensure price stability over the medium term.”

· The conditional “would” is transformed into “will”

And thus a firm commitment to move quickly.

· The instruments to be used are no longer limited to “unconventional” tools but all those at his disposal.

à This could augur a new cut in benchmark interest rates as earlier as next week, with the deposit facility rate lowered to -0.20% and the refi rate lowered to 0.05%.

Along with the expected impact of the surplus liquidity injections with the upcoming T-LTROs, this might explain why the Eonia has been trading in negative territory since yesterday for the first time ever, why yields are now negative on German sovereigns up to 3.5 years of maturity and why some investors bought a good-sized order of Euribor calls 100 March 2015 at 0.02 this morning!

· He no longer talks about “anchoring inflation expectations” (undoubtedly too late for that), but of “ensuring price stability”.

à This is the best way make his fellow Governing Council members face their responsibilities. We are no longer talking about a hypothetic danger but of a real and present danger. The inflation figures published yesterday and today (Germany 0.8% YoY, Spain -0.5%, eurozone 0.3% YoY), and German Retail Sales (-1.4% MoM vs +0.1% expected) only reinforces this view.

· Similarly, he no longer speaks of medium- and long-term actions, but solely of the medium term.

He no longer speaks of a hypothetical, future situation, but of tomorrow! Moreover, Mr Draghi added a number of lines to the initial version of his speech, probably based on the view that his previous explanations provided at his monthly press conferences no longer do the trick. Just check out the significance of this added text:

First text:

“Inflation has been on a downward path from around 2.5% in the summer of 2012 to 0.4% most recently. Acknowledging this, the Governing Council would use also unconventional instruments to safeguard the firm anchoring of inflation expectations over the medium- to long-term.”

Final version:

“Inflation has been on a downward path from around 2.5% in the summer of 2012 to 0.4% most recently. I comment on these movements about once a month in the press conference, and I have given several reasons for this downward path in inflation, saying it is because of food and energy price declines; because after mid-2012 it is mostly exchange rate appreciation that has impacted on price movements; more recently we have had the Russia-Ukraine geopolitical risks, which will also exert a negative impact on the euro area economy; and of course we had the relative price adjustment that had to happen in the stressed countries as well as high unemployment. I have said in principle most of these effects should in the end wash out because most of them are temporary in nature — though not all of them.

But I also said if this period of low inflation were to last for a prolonged period of time, the risk to price stability would increase. Inflation expectations exhibited significant declines at all horizons. The 5year/5year swap rate declined by 15 basis points to just below 2% — this is the metric that we usually use for defining medium term inflation. But if we go to shorter- and medium-term horizons, the revisions have been even more significant. The real rates on the short and medium term have gone up, on the long term they haven’t gone up because we are witnessing a decline in long-term nominal rates, not only in the euro area but everywhere really. The Governing Council will acknowledge these developments and within its mandate will use all the available instruments needed to ensure price stability over the medium term.”

AT LAST!

Readers of this letter are used to our 2- and 5-year inflation expectations graph (Thaler’s Corner of 26 November 2013: Those famous inflation expectations), which enabled me to sound the alarm at the time. I still cannot figure out why the ECB insisted on this 5-year in 5 years inflation swap indicator when the short-term indicators I used seemed more relevant. At the risk of seeing myself again caricaturised as a warmed over (post) Keynesian, I would like to once again share this excerpt:

« But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.”

‘A Tract on Monetary Reform’, John Maynard Keynes, 1923.

(219 pages for printing out, if you’re ready for a little weekend reading)

We can thus only applaud Mr Draghi’s decision to use these shorter time maturities, which are recognition that if these very low inflation figures become engrained in the public consciousness, we could be plunged into a long period of lowflation, with the enormous dangers that implies for the eurozone. So here is the updated inflation expectations graph. You will note a slight rebound of fractions of a per cent of these expectations since the ECB’s president’s speech, but there remains a long way to go.

2-Year Inflation Swaps on the Eurozone

When I updated this graph, I took the liberty of displaying with red arrows the period of ECB rate hikes, in April and July of 2011, which unsurprisingly marked the inevitable hellish descent of eurozone inflation expectations, from 2.30% to about 0.69% today. I have already written ad nauseam about these rate hikes, which typify the tunnel vision at the time of our very much unmissed former ECB chief, Jean-Claude Trichet, who is, in large part, responsible for the ensuing sovereign debt crisis. So I have nothing to add, especially since this graph speaks for itself!

5-Year Inflation Swaps on the Eurozone

We had earlier this year emphasised just how much these 5-year inflation expectations were anything but anchored (red dash oval), as they slipped below 1.40% and settled toward about 1.20%. It is really sad that they had to fall below 1% for the ECB to react, but we are at least happy that they are finally ready to act, given the severity of the situation. We shall see what measures they will take to counter this phenomenon, which explains the importance of the substance of Mr Draghi’s speech at Jackson Hole. It also constitutes his truly big surprise.

I cannot remember all the times I have railed against the ECB after it took the liberty to give fiscal budget lectures to eurozone member states. Aside from the fact that their comments fell well outside the authority of the central bank, they undermined the principle of its own autonomy, which is obviously not a one-way street. Moreover, the fact that a non-elected body endowed with such enormous power assumes the right to oversee the decisions made by democratically elected governments of the eurozone can only unsettle those of us who believe the positive civilization impact of European construct and rule by election. And the ECB president’s before the European parliament changes absolutely nothing, since that body has no power to impose sanctions. This separation of power was meant to eliminate the temptation of governments to print money, which, according to the Austrian psychosis, is the cause of all the planet’s inflationary ills. Weren’t we trained according to the teaching that “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. “?

(Milton Friedman, “The Counter-Revolution in Monetary Theory”, 1970).

But when a central bank finds itself short on ammunition (Zero Lower Bound) and is either unable or unwilling, due to institutional (or political) constraints, to venture too far from the beaten path (unconventional policies), what other choice does it have, besides co-ordinating its moves with fiscal authorities? I present below an excerpt from Mr Draghi’s speech, which he placed just after his sentence about probable ECB action (“we will use all the available instruments”), which we discussed in the first section of this newsletter:

“Turning to fiscal policy, since 2010 the euro area has suffered from fiscal policy being less available and effective, especially compared with other large advanced economies. This is not so much a consequence of high initial debt ratios – public debt is in aggregate not higher in the euro area than in the US or Japan. It reflects the fact that the central bank in those countries could act and has acted as a backstop for government funding. This is an important reason why markets spared their fiscal authorities the loss of confidence that constrained many euro area governments’ market access. This has in turn allowed fiscal consolidation in the US and Japan to be more backloaded.”

If I understand Mr Draghi’s comment, he now seems to be saying that he regrets the harshness of the austerity programmes implemented on the eurozone! We are light years from the tone we are used to hearing from the ECB. In other words, he is saying that the eurozone had the ability to act on the fiscal level, given that debt-to-GDP ratios were no higher on the zone than in the US or Japan, but that our monetary zone’s ability to act was hindered by the eurozone itself.

This reading of history is as entertaining as it is divorced from reality.

In the first place, the American and Japanese central banks never acted as “backstops for government funding”. Quite the contrary, Ben Bernanke clearly explained at the time that, for example, the QE3 was launched to counteract the fiscal belt tightening implemented by the American government, which could have sent the country back into recession or, at least, into the troubled waters of sinking inflation. Further, certain eurozone governments carried out rigorous austerity programme out of ideological conviction (Germany with its balance budget law), either because the ECB imposed such measures, because of the Troika’s interventions or because of thinly veiled threats (ciao Mr Berlusconi). That said, I am not going to harp on these controversial points today, but instead emphasise the positive aspect of his latest speech.

For example, consider the elegant way in which Mr Draghi sized up aggregate demand:

“Demand side policies are not only justified by the significant cyclical component in unemployment. They are also relevant because, given prevailing uncertainty, they help insure against the risk that a weak economy is contributing to hysteresis effects. Indeed, while in normal conditions uncertainty would imply a higher degree of caution for fear of over-shooting, at present the situation is different. The risks of “doing too little” – i.e. that cyclical unemployment becomes structural – outweigh those of “doing too much” – that is, excessive upward wage and price pressures.”

Not only is he calling on government officials to carry economic stimulus measures but highlights the risk of hysteresis, a topic we have raised on numerous occasions. And what do you think of these excerpts from his speech?

· “Without higher aggregate demand, we risk higher structural unemployment, and governments that introduce structural reforms could end up running just to stand still.”

· “The way back to higher employment, in other words, is a policy mix that combines monetary, fiscal and structural measures at the union level and at the national level.”

· “In such circumstances, due to the zero lower bound constraint, there is a real risk that monetary policy loses some effectiveness in generating aggregate demand.” I realise that the ECB president also emphasised the importance of the “stability pact” and of structural reforms, but we consider that he has given us plenty of reason to hope for a welcome change in certain European budget policies. Unfortunately, given the fact that Germany has the most fiscal space and is the country where inflation should rise in priority to rebalance intra-zone imbalances, but is not fulfilling its role as the economic locomotive for the zone, the reaction by Mr Schauble will, to put it mildly, not provoke an outburst of euphoria.

The German finance minister said:

“I know Mario Draghi very well, I think he is being overinterpreted.”

‘‘Monetary policy can only buy time. Liquidity in markets is not too low, it’s even too high. Therefore I think monetary policy has come to the end of its instruments and therefore what we urgently need is investments, regaining confidence by investors, by markets, by consumers.”

“I don’t think ECB monetary policy has the instruments to fight deflation, to be quite frank”.

“ Domestic demand is driving German growth “because we have high confidence of consumers, investors.”

“And the main reason why we have such a high confidence is because they think our public budgets are sustainable, we will stick to what we have promised and we stick with investment”.

“My French colleagues will do what’s needed in line with the rules that have been agreed again and again.”

“It’s very important that we all know in Europe – every member state — that we have to stick to structural reforms and enhance competitiveness, even in Germany.”

“We are fine actually, but if we were not to continue to enhance our competitiveness in coming years we would lose our position.”

In short, Mr Schauble decided to understand only what he wanted to understand from Mr Draghi’s speech, with respect to structural reforms, all the while remaining oblivious to the concept of aggregate demand. He persists in believing what he wants and “Merkantilismus Uber Alles”. Or, put another way, “Kameralwissenschaft Uber Alles”.

Now we shall see how things proceed on the monetary front, with the September 4th meeting right around the corner (lowering of interest rates + ABS clearly announced), and on the fiscal front, with the French call for a “European growth summit”, but we feel there is reason to hope that we are finally on the right path.

Have a good weekend!