Will Europe become the next Japan?

The most recent ECB with lower rates and asset purchases has caused consternation amongst some, brought the divergence amongst the governing council to the fore and caused analysts to worry about the ability of current ECB policy to achieve the inflation and stimulate the European economy. The ECB has struggled to achieve the inflation target following the GFC in 2008 and the sovereign debt crisis, which caused deflationary pressures to emerge more strongly and justified an increasingly expansionary policy. Despite ending its crisis-induced 30bn net asset purchases program in December 2018, interest rates were cut to –0.50%. and it restarted bond purchases to the tune of ￡20 billion

Mario Draghi’s marks his exit from the ECB with a further 10bps cut to policy rates and a €20 billion asset purchase program designed in other to stimulate the Eurozone economy and cause prices to rise to the Bank’s 2.0% target. However appropriate or ill-timed — depending on what side of the debate you stand — the current ECB policy is not completely unwarranted as dictated by the Taylor Rule and inflation which remains well below the 2.0% target. While below-target inflation more than justifies an accommodative monetary policy, the impact of the most recent policies might be negated by the adverse effects of the U.S. — China trade war, slowing global growth and political uncertainty stemming from Brexit.

Europe: How are we?

The Eurozone economy continues to reel from the impact of the 2008 financial crisis and the 2011 sovereign debt crisis. Unlike the United States and Asia, the ECB had to design a crisis-proof response, which not only sought to re-engineer economic growth and private sector demand; an overwhelming objective of monetary policy at the time addressing deflationary pressures, which caused an unprecedented expansion of the balance sheet, driven by an encompassing asset purchase program of both private and public sector bonds and record low-interest rates. Despite an unprecedented scale of asset purchases and monetary stimulus, inflation only rose tepidly, reaching 1.7% in May 2019 and averaging 1.4% and 1.5% in 2019. It is perhaps conceivable that attaining the inflation target was always going to be problematic following the financial crisis, the reasons are outlined below.

1. The inflation target was never designed to allow monetary policy flexibility and a point target was set at a time when the transmission mechanisms from tighter labor markets to consumer prices were much less nuanced. Not only was the Philips curve well and alive, but the macroeconomic backdrop was also characterized by significantly more investable projects, with direct net positive spillovers to the real economy. As our economies have become increasingly service and Intellectual property (I.P) driven, capital flows have focused process innovations, whose distributional effects tend to be more uneven and therefore, distortive for the current practice of monetary policy; one that seeks to perpetuate supply-side dynamics.
2. Central Bank inflation target was designed for a world where most advanced economies were at the “growth stage” of their life cycle. As a result, investing in factories, farms, machinery, and infrastructure created real jobs that focused on process innovations for the existing stock of labor. Rather than displace labor, it boosted productivity for workers, allowing mass production of cars, apparel, electronics, washing machines, fridges, and other consumer and non-consumer products. Increased productivity caused higher wages, but the caveat is the distribution across the labor market. Unlike recent times, where process innovations have had a less-than-positive employment shock and wages have disproportionately accrued to more skilled workers. Meanwhile, rising wages in the past meant the inflation target could be achieved more easily improving the transmission mechanisms of monetary policy. Even as unemployment has hit record lows in the United States and Britain, the FED and BoE have not consistently achieved the inflation target and the former has reduced interest rates twice — an insurance claim — as it seeks to reduce the disinflationary and contractionary effects of the U.S.-China trade war. “As such, the extent to which wage increases are evenly spread throughout the workforce influence the likelihood of monetary policy achieving the inflation target”

It is now widely known that fiscal policy will play an increasingly important role in the event of a downturn, supporting the attainment of Central Bank’s inflation target. Although there is no shortage of policymakers calling for fiscal policy to complement monetary policy, very little is said regarding the design of such policies. Increased government spending will undoubtedly support a recovery, cause unemployment to fall and wages to rise, but the inflation target is unlikely to be achieved sustainably if fiscal space isn’t used to address structural drivers of the lower potential growth rate in advanced economies. Fiscal policy should recognize underlying trends in the economy, and use wage subsidies to incentivize long-term hiring and planning in other to improve their competitiveness and productivity. Several reasons support this line of thinking.

• The oncoming monetary and fiscal response will chime in with the fourth industrial revolution, an increasingly digitized economy, and data-centric business models. As such, any fiscal response should be designed to support the retraining and digitization of the workforce in other to lessen the risk of displacement, which undoubtedly breeds economic nationalism. By using wage subsidies instead of traditional tax-payer funded tax cuts on roads, railways, and infrastructure projects, companies will be incentivized to hire and train workers in a manner that bolsters their long-term competitiveness, support productivity and improve the quality of the tax base. If governments implement traditional tax cuts, which focus on job creation instead of high-quality jobs, it will only serve to achieve a transient upshoot in inflation. The latter is particularly salient for governments in advanced economies with aging populations and changing demographics. It is widely known that the procyclical fiscal stimulus in the United States boosted economic activity and inflation to rise sustainably to the 2.0% target for a while.
• Secondly, this will incentivize new thinking around the supply and demand-side debates. Rather than focus on supply-side dynamics as illustrated in incessant bouts of quantitative easing and negative interest rates, intentional and skills-oriented labor market policies and wage subsidies will cause households’ real incomes to rise sustainably, bolster competitiveness in the labor market and prepare the labor force for changing labor market needs.
• Thirdly, the inflation target will be achieved more sustainably and the transmission from policy rates and asset purchases to the real economy will vastly improve as an increasingly skilled labor force will support an increasing service and I.P-driven economy. This will prove a boon for the transport, healthcare, climate sector, not to talk of industries likely to form around the data economy.

How should the ECB think about policy

The Eurozone economy has benefited from ultra-accommodative policies and the outgoing President’s — Mari Draghi — decision to stimulate the economy by cutting interest rates further into negative territory and restarting asset purchases to the tune of €20 billion is ill-timed not completely inappropriate.

The economic arguments for a round of renewed stimulus are clear — inflation is well below target, the Eurozone economy is slowing, plagued by global trade, geopolitical uncertainty, Brexit and sanctions. Nevertheless, the expansionary effects of negative interest rates and further asset purchases are uncertain vis-a-vis the U.S. — China trade war and fears of deglobalization amongst others.

Is continued monetary accommodation necessary?

The ECB’s most recent decision was not short of dissenters; it is plausible that continued uncertainty around global trade policy will negate the expansionary effects of negative interest rates and further asset purchases. Businesses are postponing investment decisions as a result of the trade and geopolitical uncertainty i.e U.S. — China trade and technology war as well as uncertainty regarding the timing and nature of the U.K’s exit from the European Union, if at all. As such, lowering the policy rate, whilst welcome by market participants, is unlikely to incentivize capital flows into riskier assets, renewed investments or further extension of global value chains.

Some analysts — myself included — argue that Central Banks must stop obsessing over inflation targets but rather seek to balance financial stability risks with their respective mandates. Although Mario Draghi and Jerome Powell will loathe to respond to a crisis rather than avert one, the tools to respond to a future downturn are increasingly scant. Central banks can reduce policy rates further into negative territory, reduce capital requirements or capital quay (ECB) as well as target asset purchases towards companies with minimal climate risks as well as those likely to support employment over the very long term and facilitate an increasingly digitized workforce. By no means I’m I understating the importance of inflation targets as an anchor for the economy; I do, however, think the calculus should reflect the conflicting and more lasting impact of an uncertainty-plagued world.

In other to improve the information gleaned from Central bank communication, they must ensure policy reflects the changing interactions amongst market participants. To give an example, changes in monetary policy work through financial channels in two ways. On the one hand, asset purchases and changes in interest rates affect short and long term rates, causing businesses to make informed decisions. Meanwhile, the impact on households has become increasingly nuanced as lower interest payments do not always result in additional spending; this is the challenge for economies who have seen households pick up the slack in the face of waning business investment. Although additional net worth via balance sheet effects can result in some additional spending, the global trend of monetary accommodation could also have the unfortunate consequence of reinforcing current imbalances caused by differing asset ownership structures.

The Zero lower bound…et al

There is no shortage of research discussing at what level interest is considered to be close to the effective lower bound. Depending on how much interest rates have been cut into negative territory, the distinction between the effective lower bound and zero lower bound could be nuanced. The FED for example, who despite cutting interest rates by 25bps to 1.75% — 2.0% is far from negative territory. The apprehension ascribed to negative interest rates by U.S. analysts suggests the zero lower bound means no interest is paid on reserves. Meanwhile, the ECB’s decision o further cut interest rates further into negative territory is more likely to see -1.0% or -1.50% as the effective lower bound.

But the expansionary effects of negative interest rates are uncertain, and likely to be counterproductive as Bank profit margins are affected by having to pay interest on reserves. Meanwhile, research into the impact of negative interest rates — via the Swedish banking channel — found the output in the Swedish economy fell by 7bps even as lending to households’ and businesses increased by 17bps. The question isn’t whether negative interest rates are necessary or even relevant given the adverse effects latent in their design, but whether the ECB should transition to a target band in other to prevent the de-anchoring of inflation expectations is something worth considering.

The ECB is running low on bonds and will need to invest in equities in the event of another downturn. Some argue that changing the Centra Bank’s target could reduce the confidence in the inflation target and de-anchor inflation expectations. Careful communication, clearly outlining the benefits of the target band as opposed to a point target will improve the effectiveness of monetary policy and provide greater clarity on the Central Bank’s response function should it pause if inflation falls below target. The ECB would have kept monetary policy on hold under such circumstances, allowing sufficient room for Christine Lagarde to respond to the financial crisis. She must now carefully communicate the Bank's ability to attain the inflation target with somewhat limited tools. This would have also improved the functioning of monetary policy as a fixed business investment will react more positively to lower interest rates and asset purchases in the absence of geopolitical uncertainty and rising risks of protectionism.

The ECB’s current monetary stance is appropriate — but recent changes to monetary policy are ill-timed — and will eventually achieve the 2.0% target. The challenge for its design of monetary policy and tool kit is that inflation is increasingly driven by external factors i.e oil, online competition, etc. Furthermore, headwinds stemming from the U.S.-China fallout, Brexit and a slowing global economy bode ill for inflationary pressures and economic activity. Investors are unlikely to make significant capital investments under uncertain conditions; this explains investment which is 6–14% in the U.K, with vacancies falling to 70,000 from 100,000. The current accommodative stance of central banks cannot, therefore, go unchallenged, and while signaling monetary accommodation is appropriate, the positive spillovers might be more muted than previously expected. Central Banks are essentially caught between a rock and a hard place, lowering interest rates will reduce the impact of trade and economic policy uncertainty over the near term, but the extent and intensity of positive net spillovers will be tepid at best. Although asset prices will react to lower rates, we are unlikely to see a recovery in investment in the near term.

If the ECB maintains its current trajectory of large scale asset purchases and further cuts to its policy rates, inflation will eventually converge to the 2.0% target. It will, however, be contingent on a sustained de-escalation in global trade rhetoric and slightly higher oil prices. Furthermore, a weaker Euro will make exports more competitive, but imported inflation will likely remain muted if global competition heightens and/or growth slows. A lower inflation target or implementing a target range might be the only way to prevent an exaggerated increase in the ECB’s balance sheet; although the ECB isn’t battling deflationary pressures like the BoJ, its commitment to an exogenously-driven inflation target might place undue pressure on the Bank’s balance sheet and normalize economically questionable negative interest rates.