Earlier today I put out post with ‘one graph’ illustrating just how much behind the curve the ECB is in terms of needed monetary easing. At the core of that blog post was a graph of the ‘price gap’. I defined the price gap as the percentage difference between the actual price level (measured with the GDP deflator) and a 2% path.
David Laidler has asked me how the ‘two graph’ version of the post would have looked. The other graph of course being the (broad) money supply rather than price level.
David, take a look at this graph:
We know from my earlier post that the ECB prior to 2008 basically was able to keep the actual price level very close to the ‘targeted’ price level (the 2% path). Therefore, we will also have to conclude that the actual money supply (M3) level was more or less right. Hence, if we assume an unchanged trend in money-velocity then it reasonable to also assume that the pre-crisis trend is the trend in the money supply necessary to return the price level to the pre-2008 trend.
I define the ‘money gap’ the percentage difference between the actual M3 level and the pre-2008 trend-level. The graph is extremely scary – the ‘money gap’ is now -30%! Said in another way – the ECB needs to expand M3 by 30% to bring prices back to the pre-crisis trend level or the ECB needs to engineer a massive change in expectations to push up money-velocity.
Don’t tell me that the ECB doesn’t need to do massive QE to avoid deflation…
PS I have chosen to ignore commenting on ECB’s policy decision earlier today, but lets just say that today’s action is unlikely to do much about the deflationary risks in the euro zone. Outright QE is needed.
PPS I have earlier discussed the euro zone ‘money gap’. See for example here.
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Antonia
/ June 5, 2014Lars, you are so right with this. I believe however that Mario Draghi’s tactic is, once more, to use words rather than deeds. I think today we had quite clear evidence of that. He is trying to, as you put it, “engineer a massive change in expectations.” Namely, he’s trying to convey the message that the ECB’s mandate is now closer to the Fed’s and the BoE’s – inflation and growth, rather than just price stability. http://www.marketmoving.info/mario-draghi-real-message/
If he does manage to pull this off, he might turn out to be the only central banker in history who didn’t need to buy assets on a massive scale in order to achieve QE. The question is, will he pull it off?
Lars Christensen
/ June 5, 2014Antonia,
The short answer is NO – he will never pull it off without QE. If he actually did QE AND communicated clearly about what he wanted to achieve then it would work, but now there is likely to very little macroeconomic effect. And the markets are tellling him that loud and clear – just look at breakeven inflation expectations in the euro zone. Or the euro. Yes, it has been weakening, but far too little to do anything dramatic for aggregate demand in the euro zone economy.
chris mahoney
/ June 6, 2014Lars,
You don’t understand. The ECB is successfully fulfilling its price-stability mandate. There is no money gap. The ECB (the northern part) defines its mandate as “not more than 2% inflation and not less than zero inflation”, which is the foundation of its globally-respected “credibility”. (See: Jens Weidmann, Hans-Werner Sinn and Alex Merk.) An analogy is the 1930-33 Fed, which maintained its global credibility by defending $20 gold in the face of 25% unemployment and a 1/3 decline in NGDP. Should the ECB succeed in creating 25% unemployment and a 1/3 decline in NGDP, it will have achieved a modern milestone in central bank credibility.
James
/ June 6, 2014Chris.
I think you are too pessimistic. It’s far from ideal with Draghi, but at least he’s not tightening policy like Trichet. He is “only” committing a sin of omission, not commission. It condemns most of the EZ to years of slow growth and high but not rising unemployment. And if there is a demand shock he remains “ready to act”, so taking away some of the downside tail risk. It is a rubbish situation, but not a disastrous one.
To change it we need political pressure from the electorates. And in peripheral Europe they are mostly, surprisingly, quiescent. They then get the leaders they deserve.
jamesxinxlondon
/ June 6, 2014Chris. I think that is too pessimistic. At least dragging is trying to ease policy, unlike Trichet who tightened. He’s not doing enough, or even the right thing, but his heart is in the right place, and the markets understand that.
The result will be slow growth and high but not rising unemployment. Far from ideal, sure, but not disastrous.
We need more political pressure from the electorate, and that is missing. Peripheral Europe gets the leaders it deserves.
jamesxinxlondon
/ June 6, 2014Draghi, not “dragging”. Freudian slip, there!