by Michael Grogan, First Class Analytics
For the past couple of months, I have strenuously been arguing that the current monetary policy in Europe is misguided. While a low interest rate policy seeks to promote economic growth in the Eurozone, it has done anything but – with GDP in countries such as Canada, UK and US far outpacing that of Europe.
In addition, we are now seeing serious risk of deflation, with CNBC reporting that the next five years could mean a prolonged spell of deflation for Europe similar to that experienced by Japan. Clearly, the initiatives to promote economic growth in Europe are failing. Intuitively, in an era of loose monetary policy one would expect consumers to spend more and this would hopefully result in a healthy inflation level. However, it is clear that consumers are not spending – we only need to look at Euro depreciation to tell us this; there is now speculation that the Euro could end up trading at parity with the dollar.
Despite the above concerns, Draghi is still prioritising quantitative easing, with the plan being to purchase €500bn in government debt to further stimulate the economy. In my opinion, the ECB is doing the same thing over and over again, each time expecting a different result. We have seen that so far, quantitative easing measures have not increased consumer spending – if they had, then deflation would not even be a question. In particular, a recent ECB interview on 2 January indicates that while Draghi considers inflation to be a risk, the policy mandates of the ECB do not appear set up to counter this risk:
Do you fear deflation, i.e. declining prices and wages?
Draghi: The risk cannot be ruled out completely, but it is limited. The important thing is what inflation rate people expect over the medium term. Since June, we have seen that these expectations have declined. If inflation remains low for a long time, people might expect prices to fall even further and postpone their spending. We are not there yet. But we need to tackle this risk.
… and the result is grotesque. The central bank fights for more inflation. That’s strange for Germans, whose country has suffered two periods of hyperinflation and fears a new currency reform. Do you understand the unease of the people of this country?
Draghi: History shows that falling prices can be as damaging to the prosperity and stability of our countries as high inflation. That is why our mandate is symmetric. And that is why we are now ensuring that the risk of deflation you just asked me about does not materialise. You, as a journalist, also have a duty to explain. Public opinion in Germany is very important for us.
Your intentions are good, the effects of your policies are simply not acceptable for many citizens. People are worried about their savings and pensions. They did not invest money, like Goldman Sachs, in shares, options and highly controversial bonds, but focused with your majority – rather conservatively – on savings books, German government bonds and life insurance policies. Because of the ECB’s low interest rate policy, they are currently experiencing a clear drop in wealth. Savings accounts and insurance policy pay-outs are melting.
Draghi: Interest rates have been very, very low for a long time – and they will presumably stay like that for a while longer. People see that the returns on their savings and the profits from their life insurance policies are shrinking. We understand the concerns of savers. But now let me ask a question: is that the only factor? My answer is no. After the crisis, Germany became a safe haven. A lot of money therefore flowed into the country, with the result of falling interest rates on medium and long term bonds – the interest rates of which are not set by the ECB. This has hurt some savers but also benefitted borrowers, for example those who bought houses.
Wait a minute – it was your institution which lowered the key interest rate step by step, to 0.05% at the moment. Savings are no longer worth very much in this environment.
Draghi: In an environment of widespread economic weaknesses and falling inflation, our monetary policy has to be accommodative. Is that cause or effect? We have to look at the whole euro area. If we raised interest rates, the crisis would be worse. Stability would suffer – and that would hurt investors and savers even more. We are keeping interest rates low to stimulate the real economy and to achieve price stability.
In this interview, two statements in particular stand out:
1. “If inflation remains low for a long time, people might expect prices to fall even further and postpone their spending. We are not there yet. But we need to tackle this risk.”
In my opinion, we are already there in countries such as Spain which has officially recorded negative deflation. In a low inflationary environment, consumers will not spend due to expected lower prices in the future – I believe that this scenario is more probable than Draghi is estimating.
2. “We have to look at the whole euro area. If we raised interest rates, the crisis would be worse. Stability would suffer – and that would hurt investors and savers even more. We are keeping interest rates low to stimulate the real economy and to achieve price stability.”
Firstly, keeping interest rates low is not stimulating the real economy, as good as the ECB’s intentions are. The key way of promoting price stability is through effectively managing inflation expectations. In other words, rates would have to rise slowly but there should be a definite indication of when this will happen – if consumers know prices will rise then they will spend while they are still low.
To conclude, effective management of price expectations is lacking, and this is the reason for low consumer spending and subsequent low GDP rates. Monetary policy is only effective when such expectations are effectively managed – right now they are not. To prevent further currency depreciation and stimulate consumer spending, the ECB must stop relying on quantitative easing as a sole measure for stimulating economic growth – it is not having the desired effects and the longer it persists, the harder it will be to stimulate growth when rates eventually do rise.