It is the 16th of December 2019

Everything Was Working Great... And Then Today's ECB Blog Post Left JPMorgan "Dazed And Confused"

In a historic first, earlier today ECB vice president Vitor Constancio (the same one who in October 2014 explained that the European stress tests refuse to consider a scenario with deflation  "because indeed we don't consider that deflation is going to happen" just a few months before Europe got its first deflationary print since the crisis) penned an official ECB opinion piece, some might call it a blog post, titled "In Defense of Monetary Policy" just hours after the ECB's historic "all in" gamble which included the first ever monetization of corporate bonds.

In it he tried to do two things:

  • To explain why, despite repeated rumblings that monetary policy is longer relevant, it is in fact essential, or as he says "not only is it wrong to start talking down monetary policy – it’s actually dangerous", and to do this he attempts to prove a counterfactual saying that without QE, European deflation would be far worse than it is now, and that structural reforms, while critical "it is difficult to see how they could spur growth significantly in the next two years, especially when the current problem is lack of global demand."  In other words, yes, we should no longer stimulate, but we can't stop as governments are too inefficient, and take too long to do what they have to, so we will keep stimulating.
  • The second one is both a justification for negative rates, in which far from the now accepeted reason that the ECB no longer wants to impair bank profitability, what Constancio suggests is that the only gating factor is fears about a flight to cash should rates go even more negative (and hence why the ECB has been so aggressively moving to eliminate the €500 bill).

The problem with these two points, and especially the second one, is that it runs completely counter to the entire narrative that was sloppily errected overnight as justification for today's rally, which as a reminder was that the ECB will no longer cut rates to support European banks, and that the ECB is explicitly no longer targeting a weaker Euro but instead will do everything in its power to promote credit creation (as it did with LTRO1-4, as it did with QE1 and so on).

We were not the only ones who wre left scratching our heads. In a note by JPM's Malcolm Barr, he admits that JPM is likewise "thoroughloy confused" by Constancio's blog, and says that "it is disappointing to us to see the ECB without a clear and convincing explanation for why it perceives a bound on rates at -0.4% at this point."

The explanation is simple: the ECB not only has gone all but is now grappling and adjusting the narrative to fit to whetver the market wants to hear at any given moment just to go higher. This is precisely what happened on December 4th after the ECB's last "policy failure." The problem is that Draghi's attempt to jawbone markets higher lasted only a few days.

The risk, as JPM implies, is that once Friday's buying rally fizzles not only in the US but in Europe, and all attentions turns back to the ECB for "more"... there will be nothing there, and Draghi will have to revert back to even more negative rates, to banning cash, and to reminding markets that absolutely nothing has changed.

What is most ironic, is that everything was working out great - the market was soaring for whatever reason, and the narrative had shifted to make it seem that the ECB actually knew what it was doing... and then Constancio once again spoke up and demonstrated that the ECB really has no idea what is going on!

Here is JPM's note on the topic, authored by Malcom Barr

ECB's Constancio: Dazed and confused?

ECB Vice-President Constancio has taken the unusual step up of publishing an “Opinion piece” on the ECB website (link), entitled “In Defence of Monetary Policy”. We can’t recall any instances of senior ECB officials putting pen to paper (as opposed to giving interviews) so soon after an ECB decision. In our view, two things in this piece stand out. One we would welcome, the other we find thoroughly confusing.

  • A reality check on fiscal policy and structural reform. Constancio points out that there are significant legal and political constraints on the ability of countries to use fiscal policy to stimulate growth. In his words “countries that could use fiscal space, won’t; and many that would use it, shouldn’t”. The hint that these constraints may be at least a little unhelpful reflects the drift of opinion on this issue we have been seen of late from the leadership of the ECB. What Constancio has to say about structural reform, however, cuts somewhat against the grain. Pointing out that structural reforms tend to be deflationary in the first instance, he states: “Structural reforms are essential for long-term potential growth, but it is difficult to see how they could spur growth significantly in the next two years, especially when the current problem is lack of global demand”. We agree, and it is refreshing to see the ECB acknowledge this so openly.
  • Why the bound at -0.4%? Having argued that monetary policy has had to step into the void left by other policies, Constancio argues that monetary policy has boosted growth by around two-thirds of a percentage point over the last two years. But “all policies have limits. In the case of the instruments, we are now using, this is particularly true of negative interest rates on our deposit facility. The reasons are more fundamental than just the effect on banks”. At this point Constancio cites a recent blog by Cecchetti and Schoenholtz (link), before pointing out that bank returns on equity in the Euro area went up in 2015 despite negative rates. But if it is not the impact on bank profitability that sets a limit to the usefulness of negative rates, then what is the “more fundamental” reason?

The Cecchetti and Schoenholtz blog discusses the experience in Europe to date, and notes that rates have been moved further below zero than was thought possible without beginning to trigger flight to cash by banks. They suggest that the floor on rates may be higher in large jurisdictions than in smaller, owing to economies of scale in cash holding. And they also point out that the limit may change dependent on how long rates are expected to be below zero. But they do not conclude that we have, by now, clearly reached the limits of how low negative rates could go. Moreover, the piece almost completely ignores the impact that the specific design of tiering regimes can have on the marginal incentive to hold cash (where the exemption on negative rates is withdrawn as banks’ holdings of cash rise).

So this leaves us thoroughly confused. We had thought that the ECB was turning away from further moves into negative territory because of the impact on bank profitability and, hence, on credit availability. Constancio appears to say this is not the key reason, and that the constraint from possible flight to cash is coming into view. In our view, it is not clear that either argument is convincing. But the argument for stopping at -0.4% based on impacts on bank profitability is more convincing than any suggestion that rates simply will not stick much below -0.4% because of flight to cash. It is disappointing to us to see the ECB without a clear and convincing explanation for why it perceives a bound on rates at -0.4% at this point.  

* * *

It's ok Malcolm, the ECB will just make it up as it goes along, quite literally day by day now.

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