Friday, October 26, 2012

European Central Bank May Be Experiencing Its Epiphany

No, today's headline does not refer to the Christian festival or to three wise men, but to the quasi-mystical "revelation" as defined by James Joyce. Let us hope that this "revelation" is bringing some real light to the dusty theology of the European Central Bank (ECB). The Epiphany, as defined literally, is often associated with moments of strong emotions, like those provoked by the crisis on the eurozone.

Make no mistake about it. The ECB and EU are in the process of successfully containing an even more serious crisis than that experienced in the United States during the subprime loan/CDO/money market fund upheaval. During this European crisis, the market is brutally questioning the "sovereign" quality of certain eurozone countries' debt and, by Adverse Feedbackloop effect, the euro and the European Union itself.

Although they are not about to scream it from the rooftops (their penchant for opacity being what it is), our august bank chieftains in Frankfurt may be much more concerned about their sole mandate (price stability, but the other way around this time) than is often believed. After all, this price stability mandate (the sole needle to their compass) implies not only constant vigilance against all sorts of inflationary risks, but also particularly attention to the danger of deflation, which is where things become interesting.

European monetary officials, who have historically focused so much on the growth of M3 money supply, must be more than worried about its growth, for which they had set an annual target of +4.5%, following +8.20% annual growth from 2000 and 2008, since it has been growing at a negative annual rate of -1.60% since April 2009. In the meantime, between October 2008 and April 2009, the ECB lowered its Refi rate from 4.25% to 1%!

This shows just how much the ECB seems to have lost its grip in the efficient management of "classic" monetary policy, not just in terms of the real economy but also in terms of the major monetary aggregates.

M3 is so important for the ECB because it includes all the liquid or quasi-liquid financial assets the speed of whose circulation may fuel the acceleration of money velocity, with all the inflationary implications during periods of overheating of the real economy. Aside from the obvious collapse of M3, if we take into account the change in the nature of a few other asset types, this also implies an unprecedented contraction in the velocity of money circulation.

Some (more or less) long-term assets (dynamic money market funds, CDOs, government bonds) have completely lost their "liquid" quality, due to the disparities that occurred during the non-valuation of some of them, but especially because of the disappearance of their collaterisabilisation (sic). The excessive repo market, which led to the impression that the Shadow Banking system was very liquid when it was in reality in a carry position on assets that are by nature un-mobilisable (CDO, Loans, etc.), has become ancient history.

Another example: The time when a Russian oligarch could secure the shares of his questionably audited company to invest in other assets, be they financial or trophy assets (yachts, Villa Léopold), is over.

In short, the velocity of money circulation has in reality slowed much more than neo-classic statisticians are willing to admit. Is not frankly negative velocity one of the characteristics of deleveraging periods?

Given my incurable optimism, I continue to hope that the neo-classic cataract which has been obscuring the ECB's sight is slowly clearing up, in terms of the balance between inflationary and disinflation risks. I take heart from the surprising comments in the ECB's May survey, published this morning:

ECB Survey

  • Above all, the comments by ECB members in recent days are particularly interesting, because they illustrate that:

    • The dislocation of sovereign debt markets rendered its monetary policy (even more) inefficient (restrictive).
    • The doubts we continue to have about the reality of the planned sterilisation programme, whose announced only served to reassure the bond vigilantes and stabilise inflationary anticipations.

    Jean- Claude Trichet

    • We had observed destruction of financial markets that were gravely hampering the transition of monetary policy.
    • The ECB's momentous decisions were taken in view of dysfunctional markets that hampered the normal transmission of monetary policy.
    • We are not engaging in quantitative easing.
    • We will take back all liquidity that we are adding.

    Christian Noyer

    • ECB Policy was endangered last week by market disorder.
    • Monetary policy was threatened.

    Miguel Angel Fernandez Ordonez

    • Banks’ use of the ECB’s overnight deposit facility provides some sterilization of the central bank’s government bond purchases.
    • Huge amounts of money are being put in the deposit facility. There is an automatic sterilization.


    • We have of course the possibility for the ECB to take money in from banks, but maybe we will also construct some other additional instruments.
    • This is just a discussion we are leading; there is no immediate need to draw up a sterilization plan, which ensures that the overall amount of money in circulation is not increased.
    • Because we have the deposit facility and instruments that are available and are quite substantial.
    • But it might be a good idea to expand the arsenal.

    Jose Manuel Gonzalez-Paramo

    • New ECB measures to restore monetary policy transmission
    • The bank will announce the details on how it plans to sterilize its government bond purchases next week.

    Juergen Stark

    • I see no inflation danger for the foreseeable future
    • The excess liquidity is being collected again and there arises no inflation pressure.

    The bank will hold the government bonds it buys until they mature. (I had missed that one!) The printing presses aren’t being fired up, no inflation pressures from bond purchases, which will be neutralized. What a relaxed stance by the super hawk. Has his appreciation of inflationary (deflationary) risks gradually changed with the realisation that we are undergoing a real deleveraging crisis (the latest case being the Greek government balance sheet)?

    To wrap up, check out these two graphs:

    Deflation in Ireland

    And it's not over yet….

    (Click to enlarge)

    Price and Loan Deflation in Japan

    3 distinct periods…

    (Click to enlarge)

    As you can see in the above graph, the contraction in loans to the economy by Japanese banks led to the contraction in consumer prices during phase 1 from 2000 to 2005.

    The consumer price index (excluding food and energy), which had stabilised between 1997 and 2000, following the Asian crisis, declined an at an average annual rate of 0.75% until the beginning of 2006, while neighboring economies were picking up strongly.

    One of the explanations stems from this endlessly repeated notion of ‘Credit’ and the necessary slow and painful deleveraging of the zombie banks. On the contrary, the lending rebound from the beginning of 2005 enabled, with a slight delay resulting from the delayed transmission effect, the stabilisation of consumer prices, which remained at the same level in 2009 as three years earlier.

    As such, we fear that these prices, which are clearly on a downward trend with the collapse of demand following the outbreak of the ‘Great Financial Crisis,’ may be further depressed by this new reduction in loan access to the economy. According to statistic published this morning by the Japanese Finance Ministry, loans contracted an annual -1.8% in April, following -2% in March.

    Disclosure: Author long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Greece 2 Y and 10 Y bonds

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