The ECB is embarking on a large-scale sovereign QE programme against a backdrop of accelerating monetary growth, significant exchange rate weakness, fading fiscal restraint and a major terms of trade boost from the lower oil price. ECB policy was consistently too restrictive over 2008-12; it may now be making the opposite mistake.
The ECB will buy €60 billion of government and private-sector bonds per month from March 2015. Private-sector purchases have so far been running at €12 billion per month, so this implies government buying of about €50 billion, at least initially. The programme is “intended” to continue until September 2016 and “in any case” until inflation is judged to be returning to target; this phrasing allows for both an earlier or later end. 80% of the credit risk of the government bonds purchased will be carried by national central banks. The ECB simultaneously lowered the interest rate on future targeted longer-term refinancing operations (TLTROs) by 10 basis points.
A buying rate of €60 billion per month implies €720 billion per annum, or about 7% of Eurozone annual GDP. The table compares this with recent QE programmes in the US, Japan and the UK. The ECB’s buying rate is larger relative to GDP than the Fed’s during QE3 but much smaller than the Bank of Japan’s current pace.
The size of the programme, however, needs to be judged against existing monetary conditions. The ECB has already eased policy substantially, resulting in a strong acceleration in money growth. As the table shows, narrow and broad money are rising much faster than in Japan and the UK before their most recent major QE initiatives. Monetary trends are similar to those in the US when QE3 started.
The monetary pick-up suggests that economic prospects have already improved significantly. In addition, fiscal “austerity” is ending while the lower oil price is delivering a major boost to spending power. According to the IMF, the Eurozone “structural” budget deficit was cut by 2.5% of GDP between 2011 and 2013 but will decline by only 0.3% in 2014 and 2015 combined. If the current oil price is sustained, meanwhile, the Eurozone will enjoy a reduction in its import bill of about 1.25% of GDP in 2015.
The Eurozone economy, therefore, could rebound surprisingly strongly during 2015. Today’s ECB move may come to be seen as another case of policy-makers’ actions exaggerating the economic cycle rather than serving to dampen it.
|Country||Initiative||Date||Maximum buying||Maximum buying||M1 growth||Broad M* growth|
|Value per month||% of GDP||% 6m annualised||% 6m annualised|
|*US M2 plus large time deposits & institutional money funds, Japan M3, UK M4ex, Eurozone M3|
A recent post noted that the oil price has fallen by more than 30% over six months on five previous occasions since World War Two. The global economy was stronger a year after these drops: the six-month increase in industrial output was higher than its starting level in all five cases.
Three of the five oil price falls (1991, 2001 and 2008) were associated with US / global recessions. A fourth (1998) reflected the Asian economic crisis. The 1986 decline bears the closest resemblance to today. It was partly the result of a mid-cycle global economic slowdown but the more important drivers were a large rise in non-OPEC supply and a structural reduction in demand due to energy conservation in response to a sustained high price in the early 1980s.
The first chart overlays the path of spot Brent in the mid 1980s on its recent movement, with the 1980s price rescaled by multiplying it by four. Based on the earlier episode, Brent could bottom at below $40 during the first quarter before recovering to $70-80 by end-2015.
The recovery could be stronger if non-OPEC supply is more price elastic than in the 1980s, as some analysts contend.
The oil price bottomed in July 1986. G7 industrial output growth embarked on a strong recovery soon after, reaching a boom level by late 1987 – second chart.
G7 consumer price inflation fell sharply in 1986 but retraced most of this decline in 1987 – third chart.
Falling US inflation contributed to the Federal Reserve cutting its target Fed funds rate by 2.125 percentage points between December 1985 and August 1986. The Fed, however, reversed course in December 1986 and was forced to tighten aggressively in 1987 as the economy boomed. Longer-term Treasury yields bottomed in April 1986 ahead of the oil price, moving sideways over the remainder of the year before rising sharply from March 1987 – fourth chart.
The relevant comparison today may be with the Eurozone. ECB President Draghi is using a temporary fall in headline consumer prices to push through further easing despite monetary trends and leading indicators suggesting improving economic prospects, with Germany already at full employment. In 1986, the Fed started to raise rates only four months after its final cut. Mr Draghi is likely to fire the starting gun for sovereign QE tomorrow but his ECB opponents may have strong grounds for calling for a suspension later in 2015.
The Chinese economy regained some momentum during the second half of 2014, but mixed leading indicator / monetary signals suggest that growth will remain moderate.
The six-month increase in industrial output peaked at 5.7% (not annualised) in December 2013, falling to a low of 3.0% in August 2014 before recovering to 4.4% in December*. Output rose by a strong 1.3% in December alone, partly reflecting catch-up after a below-par gain in November (when production was depressed by factory shutdowns to curb pollution in Beijing during an APEC meeting).
The economic slowdown and recovery were foreshadowed by falls followed by rises in real (i.e. inflation-adjusted) money supply M2 growth and a composite longer leading indicator – see first chart**. The leading indicator increased further in December but real money growth has fallen back since September. Monetary trends typically provide an earlier signal so this combination suggests that economic momentum will continue to strengthen in early 2015 before fading again towards mid-year.
Slightly better economic news reduces the urgency of further policy easing. Near term at least, the authorities may prefer targeted measures to cuts in reserve ratios or official interest rates, which would risk reigniting excessive stock market speculation. Record turnover in the Shanghai A share market in December was 2.4 times the previous monthly high in July 2009 – second chart.
*These figures are based on a seasonally-adjusted level series compiled by the World Bank.
**The components of the leading indicator are the NBS purchasing managers’ index, steel production, cargo handled at major seaports, the industrial sales / output ratio, residential floorspace sold and bank loans.
Yesterday’s shock decision by the Swiss National Bank (SNB) to abandon the 1.20 floor for the euro / franc rate was strange in several respects.
Fixed currency arrangements usually break down because the effort to maintain them has produced excessively restrictive or loose domestic monetary conditions. The Swiss monetary and economic backdrop, however, is benign. GDP grew by a respectable 1.9% in the year to the third quarter while domestic prices – as measured by the GDP deflator – were stable. Unemployment of 3.1% is close to its 10-year average. Monetary growth is subdued, with M3 and M1 up by 3.6% and 3.1% respectively in the year to November – see chart.
The SNB suggested yesterday that the franc’s recent weakness against the US dollar warranted allowing it to appreciate against the euro. Yet the effective exchange rate, as of Wednesday’s close, was slightly higher than a year ago. There was no depreciation to correct.
The SNB was concerned that the franc would be dragged lower by a further fall in the euro, suggesting that it expects the ECB to surprise markets with a large-scale QE package next week. Even if this scenario plays out, however, there is no obvious advantage in the SNB acting before the event.
It has been claimed that the SNB was constrained from conducting foreign exchange intervention on the necessary scale because of the size of its balance sheet, with assets currently equal to 84% of annual GDP. Any such constraint must be political rather than economic – the monetary authority of a strong currency can accumulate reserves without limit.
If Japan followed Switzerland’s accounting practice of including official currency reserves on the central bank’s balance sheet, the Bank of Japan’s assets would be 94% of GDP currently, with a further significant increase planned.
Nor was the SNB out of interest rate ammunition, as yesterday's 0.5 percentage point cut in target rates shows.
The SNB was wrong to abandon its traditional emphasis on domestic monetary stability in favour of an exchange rate target in 2011, but yesterday’s volte face was ill-timed, lacks a convincing rationale and will inflict significant short-term economic pain.
UK annual consumer price inflation fell from 1.0% in November to 0.5% in December (0.55% before rounding). The decline was entirely due to a faster rate of decline of energy prices – down an annual 5.8% in December versus 0.2% in November*. “Core” inflation – excluding energy, food, alcohol and tobacco – recovered to 1.3% last month from 1.2% in November.
This core measure understates domestic inflationary pressure because it incorporates a drag on prices of tradeable goods and services (excluding energy and food) from sterling strength in 2013 and the first half of 2014. Non-energy industrial goods prices fell by an annual 0.3% in December; without sterling’s appreciation, they might have risen by about 1%**. This suggests a negative impact on core inflation of about 0.5 percentage points***.
Sterling’s effective rate has stabilised since mid-2014 and manufactured import prices have started to recover, rising an annual 1.0% in November versus a 4% fall in March. This may be reflected in firmer consumer prices of non-energy industrial goods in early 2015.
Bank of England research confirms a large drag effect from the exchange rate on current inflation. In a speech in October, MPC member Kristin Forbes reported simulations on the Bank’s COMPASS model suggesting that 2013/14 sterling strength would cut CPI inflation by about 1 percentage point by end-2014, up from about 0.4 percentage points in the first quarter
An alternative approach to gauging domestic inflationary pressure is to focus on services inflation, which is less affected by changes in commodity prices and the exchange rate, although not impervious****. Annual services inflation was 2.3% in December versus 2.4% a year earlier.
The official consumer prices index (CPI) excludes owner-occupiers’ housing costs. The alternative CPIH measure includes such costs using a “rental equivalence” approach, but the Office for National Statistics has stated that its estimates of rental inflation are biased downwards. It recently started to publish an alternative series for owner-occupiers’ costs based on the “net acquisitions” approach; this rose by an annual 4.1% in the third quarter – see previous post for more details. An alternative measure of services inflation incorporating this series using the relevant CPIH weight stood at 3.0% in the third quarter.
The suggestion that domestically-generated inflation is above 2% is supported by recent national accounts prices data, with the caveat that these are subject to revision. The deflator for “gross value added at basic prices” – a measure of prices of domestically-produced goods and services sold both in the UK and overseas – rose by an annual 2.4% in the third quarter.
*The energy weight is 8.0%, implying an impact of -0.45 percentage points.
**Annual inflation averaged 1.0% over 2010-14.
***Based on a 39.7% weight of non-energy industrial goods in the core basket.
***Examples of effects include foods costs on catering services, energy costs on transport services and the exchange rate on foreign holidays.