‘Draghi’s framework’ – a step in the right direction

It is no secret that I for years have been very critical about the ECB’s conduct of monetary policy. In fact I strongly believe that the mess we in Europe still are in mostly is due to monetary policy failure (even though I certainly do not deny Europe’s massive structural problems).

However, I do think that the ECB – and particularly ECB chief Mario Draghi – deserves some credit for the policy measures introduced today.

It is certainly not perfect, but neither is Fed or Bank of Japan policy, but for the first time since the beginning of the Great Recession soon seven years ago the ECB is in my view taking a major step in the right direction. It will not solve all of Europe’s problems – far from it – but I believe this will be quite helpful in curbing the strong deflationary pressures in the European economy.

The glass is half-full rather than half-empty

Below I will highlight a number of the things that I think is positive about today’s policy announcement.

1) The ECB’s nominal target has been made more clear

One thing that the Market Monetarists again and again have stressed is that central banks should be clear about their nominal targets. Even though I like other Market Monetarists prefer NGDP targeting I think that it should be welcomed that Mario Draghi and the ECB today was a lot clearer on the inflation target than ever before.

Furthermore, Draghi for the first time clearly acknowledged that the ECB was not living up to its commitment to ensure price stability interpreted as close to 2% inflation. By doing so Draghi quite clearly signaled that future possible changes in the amount of QE will dependent on the outlook for hitting the inflation target.

2) Draghi speaks in terms of market expectations

It was also notable that Draghi at the press conference following the monetary policy announcement again and again referred to the markets’ inflation expectations and he stressed that since market expectations for inflation are below 2% the ECB does not fulfil its target. That to me is quite a Market Monetarist – it is about ‘targeting the forecast’ more than anything else. At the time the ECB’s own forecasts played a much less prominent role in Draghi’s presentation. That I consider to be quite positive.

3) The ECB is using the right instrument

A major positive is that the ECB now finally seems to be focusing on the right instrument. The only mentioning of ‘interest rates’ was basically the announcement that the policy rates had been kept unchanged.

Furthermore, there was no talk about ‘credit policy’ and attempts to distort relative prices in the European fixed income markets.

Instead it was straight-forward about money base control. That I consider to be very positive. Now we have to hope that the ECB will continue to focus on money base growth rather than on interest rates. Furthermore, by focusing on money base growth (quantitative easing) the ECB signals clearly to the markets that there are no institutional or legal restrictions on the ECB’s ability/possibility to create money. That will make it significantly easier for the markets to trust the ECB to be committed to ensuring nominal stability.

4) The programme is fairly well ‘calibrated’

One can clearly debate what is the “right number” in terms of the necessary quantitative easing necessary to take the euro zone out of the deflationary mess. I have earlier argued that the ECB essentially should target 10% M3 growth in a number of years to undo past monetary policy sins (see here, here and here.)

The programme announced by the ECB – essentially 60bn euros QE per months until September 2016 is not in any way big enough to undo past sins, however, it is nonetheless sizable.

In fact if we assume that the trend in M3 growth we have seen during 2014 is maintained during 2015-16 and we add 60bn euros extra to that every single month until September 2016 then the pick-up in M3 growth will be substantial. In fact already by the end of this year M3 growth could hit 10% and remain at 8-9% all through 2016.

This is of course is under an assumption that there is no decline in the money-multiplier. I believe that is a fair assumption. In fact one can easily argue that it is likely that the money-multiplier will likely increase in response to the ECB money base expansion.

Hence, even though we will not close the ‘gap’ from past mistakes it looks likes ECB’s QE programme could provide quite substantial monetary stimulus and likely large enough to significantly lift nominal GDP growth during 2015 and 2016, which in turn likely will bring euro inflation back in line with the ECB’s 2% inflation target.

That said, the ECB has essentially failed to hit its inflation target since 2008 (leaving out negative supply shocks) and one can therefore argue that even 10% M3 growth will not be enough to lift inflation to 2% given the markets’ lack of trust in ECB’s willingness to do everything to provide nominal stability. Therefore, commitment on the ECB’s part to continue some form of QE also after September 2016 therefore might be necessary (more on that below.)

5) The programme is quasi-open-ended

Given the considerations above it is also very important that the ECB QE programme apparently is of a quasi-open-ended nature. So while the ECB plans for the program to end in September 2016 it should be noted that the ECB in its statements today said that the programme will run until “at least” September 2016. Hence, this is likely a signal that the programme could and will be extended if needed to meet the ECB’s 2% inflation target.

The quasi-open-ended nature of the programme opens the door for the ECB to communicate in terms of two dimensions – how long the programme will run and the monthly growth rate of the money base. That in turn could potentially – if we make a very optimistic assessment – bring us to a situation where the ECB becomes focused on money base control rather than interest rate targeting.

So overall the more I digest the details in the ECB new QE programme the more upbeat I have become about it. That is not to say that the program is perfect – far from it, but it is nonetheless in my view the biggest and most positive step undertaken by the ECB since crisis hit in 2008.

Things can still go badly wrong – and we are not out of the crisis yet

There is a lots of things that can go wrong – there is for example a clear risk that massive German resistance against the programme will undermine the credibility of the programme or that the ECB now thinks everything is fine and that no more work on the programme is needed. Therefore, to ensure success the ECB needs to work on the details of the QE programme in the coming weeks and months.

In the coming days I will try to write a couple of blog posts where I will try to come with recommendations on how to improve the ‘Draghi framework’. Particularly I will stress that the ECB needs to move closer to a purely rule-based framework rather than a discretionary framework. We are still someway away from that.

PS The markets’ judgement of the ECB’s new QE programme has been positive – European (and US) stocks are up, inflation expectations are up and the euro is weaker on the day. However, the markets’ reaction is significantly smaller than one could have hoped for given the scale of the programme. This illustrates just how big problems the ECB still has with its credibility. It will take time and hard work from the ECB to change that perception – seeing is believing.

PPS I was very happy today to see that the ECB did not just introduce yet another acronym for some new useless credit policies.

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6 Comments

  1. Blair

     /  January 23, 2015

    Thanks Lars, best take on the ECB announcement I have seen.

    Reply
  2. Lawrence Kudlow

     /  January 23, 2015

    Lars, as an avid reader of your blogs I always appreciate your analysis and opinion. But one thought on ECB QE. The money multiplier collapsed in the US, as did velocity. Consequently, base build-up did not translate into rapid M2 growth, or a big bulge in NGDP or inflation.

    I believe this was principally a function of massive risk-free cash demands by banks and consumerss. Old-fashioned cash hoarding after ’08 meltdown.

    Europe may go through a similar experience, off-setting the intended base surge.

    Very best,

    Larry Kudlow

    Date: Thu, 22 Jan 2015 22:46:14 +0000 To: lkudlowny@hotmail.com

    Reply
    • Thanks for the comments Larry. It is much appreciated.

      I think that it is important to notice that interest rates on excess reserves in the US caused the collapse in the US money-multiplier. We do not have the same effect in the euro zone. In fact the money-multiplier has increased significantly since 2012.

      I admit that there is a risk that we could see bank “hoard” all the base money created, but the opposite is certainly also a possibility and the cash injection is likely to lift some of the pressure on banks particularly in South Europe.

      Furthermore, I think that we could see an increase in M3-velocity as inflation expectations hopefully continue to pick-up.

      Am I too optimistic? Maybe and I most admit I feel uncomfortable being this positive about any action from the ECB, but there is no way around it – this is the best policy step taken by the ECB since the start of the crisis.

      Reply
  3. james in london

     /  January 23, 2015

    Excellent blog. And what’s more, you really get the feeling that if this round of SQE doesn’t work as Draghi wants, he will do more.

    I hear many market experts (ie Scott’s old bugbear of those “financial market types”) now openly talking of NGDP growth as a key issuue. There really is a sea-change underway.

    eg
    “European Equity Strategy — Welcome to Planet QE — Nominal GDP Growth Put Deployed
    Welcome to Planet QE. By year-end, we expect: 1) rising Euro Area nominal GDP growth, 2) further € weakness, 3) higher asset prices. Citi economists expect EA nominal GDP growth to rise from 1.2% in 2015E to 3.5% in 2016E; we look for stocks/strategies which could benefit.”

    Imagine if Draghi talked about nominal stability instead of just price stability. in fact, I thought I did hear him say it or was I dreaming. It was close, I felt.

    Reply
  4. Great analysis, Lars. It’s hard to understand why this kind of announcement took so long, but finally the ECB seems to be sensible. Most probably there will be now enough time to plan the dismantling of euro in orderly fashion or plan how to proceed with the federation.

    Reply
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