Inflation nuttiness in the ECB

Posted by Tim Congdon in Article Archive | 0 comments

Consumer prices in the Eurozone were static for most of 2009, but the latest annual rate of change has been affected by large increases in oil and other energy prices. The price of crude oil virtually doubled in the year to December 2009/January 2010, as the OPEC member states restored production discipline after the mayhem of late 2008. Despite the oil and energy price movements, the increase in Eurozone consumer prices (i.e., “prices in the shops”, roughly) in the year to February was only 0.9%, while in the year to January producer prices (i.e., “prices at factory gates”) were down 1.0%. Underlying inflation pressures are non-existent. In fact, over the next few months more companies plan to cut prices than to raise them.

Regardless of fact, some economists are always worried about a future rise in inflation. The late Lord George, governor of the Bank of England from 1993 to 2003, famously ridiculed such people as “inflation nutters”. A recent speech given by Jurgen Stark, the ECB director responsible for economic and monetary analysis (i.e., “the ECB’s chief economist”), has to be described as a bad case of “inflation nuttiness”. Despite a reputation as an economist who believes in the macroeconomic importance of the quantity of money, the speech (given on the 16th March to the European Parliament) said almost nothing about the current collapse in Eurozone money growth. It did not draw the conclusion that the – largely because the M3 money measure has not changed in the last year – the Eurozone could face deflation in late 2010 and 2011. Many Eurozone banks are still anxious that they would be unable to fund their assets if the ECB withdrew its refinancing facilities. Stark’s message – that these facilities, which he termed “non-standard measures”, must be phased out “to avoid risks to price stability at a later stage” – must be characterised as inflation nuttiness of a high order.

Money, inflation and deflation in the Eurozone

The European Central Bank is widely believed to have inherited an intellectual legacy of “pragmatic monetarism” from the Bundesbank. Its first chief economist, Otmar Issing, defied criticism from Anglo-American economists and insisted that the quantity of money, by which he meant a broadly-defined measure such as M3, mattered crucially to the inflation or deflation outlook. At least in principle the Bundesbank influence might have been expected to ensure reasonable stability in Eurozone M3 growth. As the following chart shows, such stability was indeed maintained (more or less) until Issing’s retirement in 2006, but since then money has seen a marked boom-and-bust pattern. The chief economist who succeeded Issing, Jurgen Stark, also has a Bundesbank background, but seems to pay less attention to the behaviour of the quantity of money.The continung crash in Eurozone money growth

Standard procedure in the Bundesbank was to set a money target by proposing a desired rate of growth of nominal national income and assuming that the ratio of money to national income would rise slightly (i.e., velocity would fall). That usually generated a target money growth number of 4% to 6% a year. As the chart shows, in the year to January Eurozone M3 did not grow at all, while in the last few months it has been falling. If one subtracts a trend growth rate of output and a factor to allow for falling velocity, no change in broad money must imply a falling price level, i.e., deflation. All sorts of caveats have immediately to be lodged here, particularly the possibility that – with virtually zero short-term interest rates – people and companies will want to hold a lower ratio of interest-bearing money to income (i.e., velocity may rise). Nevertheless, a traditional Bundesbank analysis would argue that today is emphatically not the right moment to warn about future risks of rising inflation.

But – in his speech on 16th March to the European Parliament – Stark chose to do precisely that. For most of the last decade, when money growth has averaged just over 7% a year, the average increase in consumer prices has been slightly higher than 2%. According to Stark, at present “inflation expectations remain firmly anchored in line with our aim of keeping inflation rates below, but close to, 2% over the medium term”. But – if money is relevant to the inflation outlook – why hasn’t Stark adjusted his forecast for inflation downwards to reflect the drop in money growth from 10% in 2007 and the 7% medium-term average to the present figure of zero?

Recent survey evidence on inflation/deflation pressure

Money trends are a fundamental influence on inflation and deflation over the long run, but can be misleading in short runs of a few months or quarters. A cross-check is provided by business surveys, which often ask questions about price-raising intentions. The chart below is based on a monthly survey which has been regularly compiled by the European Commission since 1985. It relates to all companies in the Eurozone and shows the net balance planning to raise or lower prices. In the 25 years to 2010 on average a net balance of 7.5% of companies has planned to raise prices. At present the net balance is minus 4 per cent.Companies' pricing intentions in Eurozone countries, 1985 - 2010

Moreover, it is minus 4% even though companies have had to absorb the large increases in oil prices, and related energy costs, in the relatively recent past. The verdict must be, while there may be upward pressures on prices in some industries, these are more than offset by downward pressures in other industries. Overall, the prospect must be for continued falls in the prices of goods at factory gates and the resumption of deflation at the retail level.

What will happen to money growth from here?

Stark’s anxiety about a revival of inflation might make sense if rapid money growth were about to return. A vital pointer to money growth trends is survey evidence on banks’ intentions to lend to the rest of the economy, and so to expand their assets and deposit liabilities. (One might comment – incidentally – that Stark and his team seemed wholly indifferent to the potential inflation risks in 2006 and early 2007 when the annual rate of M3 growth was in the double digits. Is it possible that they pay next to no attention to money numbers, despite the “monetarist ideology” that is sometimes ascribed to them?) The ECB does conduct a survey of banks’ lending intentions, with the latest being published in January. It reported that the pace of net tightening of credit standards had eased, which sounds reassuring. However, its words need to be interpreted carefully.The ECB's 'refinancing facilities' (i.e., loans) to Eurozone banks since late 2008

The meaning of the survey was that in late 2009 Eurozone banks were still tightening credit standards, even if the tightening was proceeding at a slower rate. As far as their customers were concerned, banks’ credit facilities were therefore becoming less available, more costly and so on. Part of the explanation was the pressure on banks to raise capital/asset ratios, but also relevant were concerns about their ability to fund future asset acquisition from the inter- bank market. The survey did in fact include a section on “Impact of the financial turmoil on the access to wholesale funding”, which was generally rather complacent. In its words, “A net percentage of respectively 17% and 10% of responding banks reported some easing in access to funding on the very short-term and short-term money markets.” But it is difficult to square these remarks with one vital piece of evidence about Eurozone banks’ funding position. This is that their borrowings from the ECB remained at the end of February – and almost certainly remain at the time of writing – not far from the highest levels in the current crisis. The peak level of the ECB’s “refinancing facilities” was in June 2009 at about 900b. euros, when Ireland’s banks in particular were in great danger of being unable to roll over its liabilities. The latest figure in the ECB’s Monthly Bulletin was 726.9b. euros at the end of February, only a little less than the average since the intensification of the crisis in late 2008. Moreover, as the chart above shows, the proportion of long-term facilities to the total is far higher now than 18 months ago. The impression given by the chart is that Eurozone banks’ depend just as heavily on the Eurosystem (i.e., the central banks) to fund their assets as at the worst moments in the crisis. If the banks’ access to the ECB’s facilities were curtailed, they would inevitably react by limiting credit lines to their own customers.Recent trends in bank lending to the private sector in the Eurozone

So why this talk about “exit from non-standard measures”?

The discussion has a clear-cut and obvious conclusion, that the early withdrawal of the ECB’s refinancing facilities will aggravate the credit crunch now facing banks and their customers across the Eurozone. Bank credit growth is virtually nil and, since assets and liabilities must be equal, to also is the growth of broad money. Many banks have been limiting credit because they have been concerned that they will not be able to fund their assets in coming quarters. For them the ending of the refinancing facilities (i.e., the ability to borrow on a six-month or longer basis at a 1% rate) would be a major business headache. Of course, it is the banks in Ireland and Greece that are most vulnerable.Central Bank  of Ireland's lending to Euro area credit  institutions

Why in these circumstances is Stark talking tough? In his speech he said that the exit from non-standard measures had begun in December, while the ECB Governing Council had decided that “the six-month operation coming up in two weeks will be the last”. The shorter- term refinancing facilities are to remain in place until the autumn, but the very cheap fixed 1% rate is soon to disappear. In Stark’s words, “we decided to return to variable rate tenders in the regular three-month operations towards the end of April.” Assuming that the ECB does translate Stark’s words into action, it is surely inevitable that those banks currently dependent on ECB facilities will become even more reluctant to lend to companies and individuals. The Eurozone’s credit crunch and money freeze will persist for the rest of 2010, and could even get worse. (Presumably the implications of withdrawing the ECB refinancing facilities for the Irish banks have been discussed at a high level and are deemed acceptable. Presumably.)

Wider macroeconomic consequences

If the OPEC cartel had not re-established control over the international oil market and so forced prices up from their lows in late 2008, the annual changes in both consumer prices and producer prices would now be in negative territory in the Eurozone. Business conditions are not too bad in the big countries (Germany, France and Italy), although they are far from buoyant. But in the PIIGS/Club Med the latest surveys have generally been dispiriting, and point towards stagnation or contraction in output and employment. More Eurozone companies expect to cut prices than to raise them in the next few months. It follows that inflation is not a problem anywhere in the Eurozone at present and is not likely to become so for several quarters. The more serious threat is deflation, particularly in the economically afflicted PIIGS/Club Med countries.

At the start of the crisis, back in late 2007, the ECB went out of its way to be helpful to its member banks, offering them large and very cheap refinancing facilities against undemanding collateral. Its attitude was different from the Bank of England’s, where the governor, Mervyn King, said that the central bank could not be expected to provide long-term finance to the banking industry. For banks operating in both the UK and the Eurozone the contrast in the central banks’ responses to the crisis had – and continues to have – an important message for profits and the conduct of business. Bluntly, the UK’s banks were initially dealt a poor hand by their monetary and regulatory authorities, whereas some of their European competitors held the trumps. Stark is now insisting that the non-standard measures must be withdrawn. Has the ECB come to believe that its non-standard measures have been unfair and inappropriate? Is this the rationale for the ECB’s position?

Two excerpts from an interview given by the ECB president, Jean-Claude Trichet, to Le Point on 17th March, 2010

The ECB’s exit from the non-standard measures certainly appears premature given the Eurozone’s wider macroeconomic context. Many banks – notably Irish and Greek banks – will have difficulty replacing the long-term financing they have been receiving from the ECB. Contrary to Stark’s analysis, the main threat to Eurozone monetary stability is now deflation, not inflation. To worry about rising medium-term inflation risks when the quantity of money has stopped growing is surely “inflation nuttiness” of an extreme kind.

Or is there another motive for Stark’s apparent toughness? Is the imminent exit from non- standard measures part of a deliberate German (or Franco-German) plan to make life harder for banks in the awkward squad countries (i.e., the Club Med/PIIGS) and to force these countries out of the Eurozone unless they play by the rules? Who knows? The Eurozone crisis is far from over.

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