Some disparate notes

I have recently given some interviews and participated to meetings with investors. To prepare for these events I have jotted down some notes. I thought it would be useful to share them with the readers of my blog.

• ECB’s Quantitative Easing (QE) and forward guidance

The ECB has engaged since quite some months into a subtle, and I would say effective, communication tactics. Indeed it has managed to “taper” from 80 to 30 billion purchases per month in QE, while vigorously denying that it was tapering and avoiding any significant “taper tantrum”. It also resorted to the trick, in the monetary account, of saying that it was premature to change communication, which is of course a soft way to change communication.

At the same time it has put more and more weight on the “stock” interpretation of the effect of QE and less and less on the “flow” interpretation, which comes handy at a time when you are substantially reducing and eventually ending the flow, while promising to maintain the stock for quite some time longer. Central banks, not only the ECB but also the FED, have traditionally put more weight on the stock rather than the flow interpretation of QE, consistently with an equilibrium view of the functioning of the capital market. But the ECB is currently further emphasising that its portfolio will remain very heavily invested in bonds as the flow of purchases dwindles.

I think that this further emphasis on the stock is also objectively justified: it is my sense that the effectiveness of purchases has been gradually wearing off and that the stock effect is now prevalent.

Analogously, the ECB is putting more emphasis on forward guidance. In this respect it should also be mentioned that the issue whether QE will be stopped in September or will be gradually brought down (of course not tapered!) in the last quarter of 2018 is not important by itself but because it will delay by a quarter the beginning of the period from which to start counting the “well past the horizon of the net asset purchases” for the first interest rate increase.

I must confess, about forward guidance, that I always thought that this was of secondary importance. To put it simply, I do not see that it really adds much to the statement that is implicit in the 2.00% inflation objective: “We will not increase interest rates until we will be convinced that we will reach close to 2% in the medium term”.

I take the recent declarations of Peter Praet, widely considered the Executive Board Member closer to President Draghi, as another ruse in the ECB’s communication about the gradual move towards exiting from the program. However, the recent uncertainty about the strength of the expansion reinforces the view that no decision will be taken at the forthcoming meeting, while hinting that it would be taken in July.

Let me add that I do not believe that whatever will happen in Italy will have anything more than a very marginal effect on the decision to terminate QE. This conclusion of mine is based on two reasons:
o The governing Council of the ECB will rightly refuse to help a country that does not help itself, neither will it want, however, to “punish” Italy,
o Since the cause of the Italian tremors is not economic but rather political, any action of the ECB will be ineffective.

• Can we believe that the renewed confidence of the ECB in reaching its inflation objective is this time justified?

Of course the phenomenon of very low inflation, notwithstanding the double effect of historically unprecedented low interest rates and low unemployment (in particular in the US and Germany), is not exclusive of the EU or the euro-area; a similar phenomenon has been visible for a long while in the US, Japan and some other advanced economies. In the US, though, prospects are clearly changing and attention is devoted to the two sides of the inflation objectives: could inflation be too high after having been too low for a long while?

In the Euro-area a consensus is emerging about inflation, based on two conclusions:
• German inflation is acting like a cap on the inflation of other countries. The reason for this is that Germany has accumulated a big competitive advantage in the first decade of monetary union and the other economies, especially in the periphery, have to recover competitiveness, with a rate of inflation lower than in Germany. But if inflation in Germany is too low, this implies negative inflation in the periphery. However, negative inflation is macro-economically costly, given the nominal rigidity of wages. Thus a somewhat higher rate of inflation in Germany is needed for other countries to regain competitiveness without forcing wages in negative territory.
• Special factors kept inflation low in Germany notwithstanding full employment. The ECB has consistently overestimated wage growth and underestimated employment, in the entire euro-area as well as in Germany. The price of labour turned out lower than forecast and its quantity, employment, higher. This can only have been caused by an increase of the supply of labour. This mostly came from immigrants in Germany, in particular from other EU countries, but also from higher female and elderly participation. These two last factors mostly worked through part-time employment. It is however foreseen that supply side factors should become less important going forward, bringing about a stronger effect of lower unemployment and higher activity on wages and inflation. The recent German wage agreements with Metall workers (IG Metall) and public employees (Verdi) tentatively indicate that wages are growing above 3% and close to 4%, thus creating some room for positive wages growth in other countries, thus helping moving towards the holy land of 2% inflation in the medium term for the entire euro-area.

• About the importance of the next ECB President.

Of course it is important who the next ECB President will be, and for two main reasons:
• With the crisis requiring quick and bold decisions, the ECB has become a more presidential organization,
• The GC Council is too numerous a body to work smoothly and the role of the President is as a consequence enhanced.

Of course, this does not mean either that the ECB has become a monocratic institution. The GC and the EB are collegiate bodies and the dynamics within them, between hawks and doves and between the partly overlapping groups of creditors and debtors, is still important. One way to measure the importance of the President is to assess the degree of continuity between Trichet and Draghi in monetary policy terms. I stress that the evaluation should be conducted exclusively from the point of view of monetary policy, because the two Presidents have very different leadership styles and there is little continuity in his respect.

In terms of monetary policy, instead, there is a good degree of continuity. While attention concentrates on Draghi’s QE, what in my latest book with T. Välimäki I call balance sheet management , i.e. the tool central banks have invented during the crisis to complement interest rate management, was started well before QE by Trichet with the fixed rate full allotment and then the Securities Market Program. It is therefore wrong to take QE as an abrupt innovation in the ECB policy, as it is more a development than a break. In a way QE is the son of innovations brought in by Trichet.

As regards Draghi’s succession in October of next year, overall, I think Weidmann has good chances to become the next ECB President.

Let me mention the arguments for and against Weidmann as Draghi’s successor:
FOR
• Weidmann is personally a good candidate, having the necessary competences and C.V.,
• Putting a German, and even more a Bundesbanker, at the top of the ECB should help making German public opinion less hostile to the ECB,
• As largest country in the €-area and as its dominant anchor of stability, it makes sense having a German at the helm,
• Weidmann has substantially toned down his opposition to non-standard measures, from outright, principled opposition to tolerance,
• Now that Trichet and Draghi have done the “dirty work” of non-standard measures and the situation is normalizing, Weidmann can be seen as the person that brings the ECB back to orthodoxy, without this impairing an adequate conduct of monetary policy.
AGAINST
• Notwithstanding what I said about milder opposition, Weidmann is clearly far from the GC median voter,
• While there is less need of non-standard measure now, given the normalization of the economic situation, one is not sure whether non-standard measures may be needed again in the future, during Weidmann’s tenure, and his ability and willingness to have recourse to them is doubtful,
• If Weidmann would take the chair, S. Lautenschlager should leave the Board, which could be difficult also because of gender issues. The problem would be mitigated if a lady would take the “Italian slot” (provided there will continue to be one). Further occasions to rebalance the gender division in the Executive Board would be given by the stepping down of Peter Praet and Benoit Coeure.

Overall, as I have five reasons in favour and three against, you may understand why I think Weidmann has good chances. Still, of course, there are many, possibly more important factors of political nature that will impact on the choice, so the issue remains very much open.

I plan to publish some thoughts about the Italian situation in the next few days.

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