The European Central Bank (ECB) is ignoring signs of deflationary pressures in the eurozone and by refusing to ease monetary policy further it is pushing the area into a Japan-like slow growth situation, Lars Christensen, global chief analyst at Danske Bank, told Emerging Markets.
The crisis in the eurozone has affected growth in even the most buoyant emerging markets and they, especially the most vulnerable Central and Eastern European economies, risk getting drawn into the single currency area’s woes, Christensen said.
The ECB meets on September 6 to decide on future monetary policy and the markets have been encouraged by previous statements by President Mario Draghi that the bank stands ready to buy bonds.
Analysts are divided over what the central bank could and should do to put an end to the debt crisis, with some telling Euromoney magazine that the “nuclear option” would be yield or spread targeting.
“I do believe, strongly, that the ECB can solve this crisis with the snap of a finger: monetary easing. Massive monetary easing, “ Christensen told Emerging Markets in an interview.
“The ECB’s monetary policy has been extremely tight for the last four years. There is basically no money supply growth. We are seeing a little bit of money supply growth but... in the old days, the ECB were targeting 4.5 percent M3 growth. We have had M3 growth well below that now for four years.”
M3 money supply is a more general measure of cash in the eurozone economy and includes cash in circulation and overnight deposits, deposits with a maturity of up to two years, deposits redeemable at notice of up to three months, money market fund shares and units and debt securities with a maturity of up to two years.
DEFLATIONARY PRESSURES
M3, along with the harmonized index of consumer prices (HICP) for the eurozone, is one of the two indicators watched by the ECB when deciding monetary policy and while the target for HIPC is 2 percent, the reference target for M3 growth is 4.5 percent.
ECB data showed M3 three-month moving average growth rates of 1.8 percent in 2010 and 2 percent in 2011. Growth picked up in the first and second quarters of 2012, with the three-month moving average edging up by 2.9 percent and 3.4 percent respectively.
The low level of M3 shows that deflationary pressures build up and it is time for the ECB to ease monetary policy, Christensen argued.
“If the ECB moved to increase money supply growth more aggressively, the crisis would end. This is a monetary policy failure, nothing else,” he said.
A central bank should increase or decrease the supply of money to fit the needs of the economy and the best way to do that for the ECB right now would be to buy bonds, but “we’re very, very far away from that,” Christensen added. “What the market is hoping now is that the ECB will do some kind of targeted intervention to push down Spanish, Italian, Portuguese, Irish bond yields, maybe capping the bond yields at a certain level. I do think that that would help, I don’t think it’s the best policy, I’m not terribly excited about it but I do think it would help.”
ECB President Mario Draghi has maintained that the central bank will act only within its mandate, with some analysts accusing him of echoing the views of Germany’s Bundesbank, which is obsessed with fighting inflation, the main fear of Germans who have been through periods of hyperinflation.
On Wednesday, the ECB published on its website an article that Draghi wrote for German newspaper Die Zeit, in which he reiterated that the ECB will do what was needed to ensure price stability, that it would remain independent and that it would always act within the limits of its mandate.
“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools,” Draghi also wrote, explaining that when markets are fragmented or influenced by “irrational fears,” monetary policy is not transmitted equally in the single currency area.
“We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole,” he said.
‘CALVINIST’ EUROPE
Christensen believes buying bonds would be well within the ECB’s mandate.
“They have a mandate to ensure price stability and at the moment they’re not ensuring that, they’re ensuring deflationary pressures,” he said.
The central bank could buy other assets – such as stocks and foreign currency - or ease policy via open-market operations if it does not want to buy government bonds for fear this would go against the principle of not monetizing member states’ debt, he added.
“They’re targeting a headline [inflation] number which includes import prices and indirect taxes, so we have this paradoxical situation that when they do austerity measures and increase VAT around Europe, inflation in the eurozone is higher and the ECB refuses to ease monetary policy.”
“But if you look for example at the GDP deflator, there has been no inflation and there is no inflation, if you look at bond yields, you have historically low German yields. If there were real inflationary fears in Europe, bond yields wouldn’t be historically low, they would be historically high.”
Even though Spanish and Italian yields increased, Christensen said this was only because of the risk premium and that if the credit risk were taken out, inflationary expectations were low even in eurozone periphery countries.
He also pointed out that property prices were falling and that European equity markets were under-performing, saying that all signs point to deflationary pressures in Europe this year.
“The Germans tended to be monetarists in the old days, now when there is no money supply growth, they forgot about that. We should be as worried about deflation as we are about inflation. In fact we should be much more worried about deflation, that’s what we’re getting now.”
Monetary policy is “extremely tight” both in Europe and in Japan and while it is difficult to say whether in Europe that will lead to outright deflation or a disinflationary environment, it certainly is not an environment that generates sustained growth, Christensen said.
“If you look at Europe, it feels very Calvinist. We have sinned, we have to repent for years and years and years and work hard, and have no fun and no growth, save a lot... all those are very good virtues but at the moment, that’s actually not what is needed.”