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Brendan Brown, Reprinted with permission Mises Institute
Old, absurd, and unfit for purpose; how else to describe the “new” monetary framework for euro monetary policy presented by ECB Chief Lagarde amidst much fanfare on Thursday, July 8?
Why old? The “new” framework is remarkably similar to that unveiled in May 2003.
Why absurd? The main rationale put forward for the framework is to work around a problem of the “zero bound”. That problem, however, is of the ECB’s own making.
Why unfit for purpose? Chief Christine Lagarde tells us that the review has been undertaken to make sure that “our monetary policy strategy is fit for purpose both today and in the future”. But she considers no critique of that strategy and advances no rebuttal of any. She does not explain why she expects better results from a plan that so similar to the strategy that's been pursued during the past quarter century.
The ECB has upped its inflation target.
So what is now new? “Just below 2 per cent”, the 2003 formulation, has been replaced by “2 per cent”. Deep in the text of the new framework is reference to knowledge gained since then about the severity of monetary policy paralysis which can occur when inflation falls too far. This discovery, we're told, justifies greater leniency in accepting an inflation overshoot for some time. The reader then arrives at the gobbledygook phrase “price stability is best maintained by aiming for a 2 per cent inflation target over the medium term”.
The ECB has adopted many new radical tools to make this happen. Following on from the 2 per cent statement, the ECB confirms the setting of interest rates remains the primary tool, but many other tools are available as well:
The Governing Council also confirmed that the set of ECB interest rates remains the primary monetary policy instrument. Other instruments, such as forward guidance, asset purchases and longer-term refinancing operations, that over the past decade have helped mitigate the limitations generated by the lower bound on nominal interest rates will remain an integral part of the ECB"s toolkit, to be used as appropriate.
In other words, the new plan tells us the ECB plans to be much more activist and it plans to use many "tools" that were once considered to be unacceptably radical.
Think back to Spring 2003 when Professor Otmar Issing introduced the ECB’s then-new framework. The salient point then was that the ECB would aim for inflation of just under 2 per cent, ready to take as determined action to prevent inflation undershoots as well as overshoots. In response to a question, he insisted that the ECB had been following in practice this policy framework since the launch of the euro (1999), even though its formal aim had been simply inflation below 2 per cent, which in principle could have meant inflation for most of the time at zero.
At the time of the last review Professor Issing was still highly respectful about a second pillar of ECB policymaking founded on a monitoring range for broad money supply growth. There was no mention then of QE, forward guidance, long-term rate manipulation and these tools were not accepted as legitimate. Legitimacy and application of such “non-conventional tools” came in the midst of the sovereign and banking debt crises of 2010-12. They were introduced as essential for monetary control. Everyone and their dog, however, realized that their primary purpose was for the ECB to effect massive transfers of funds towards supporting the weak sovereigns and their banks. Now that pretense has become part of the new framework.
One might have expected some pushback against all this from the Bundesbank or the Dutch National Bank. There is no evidence of this except indirectly in the concession by ECB of a quid pro quo. Its review states that the estimation of inflation for targeting should be modified eventually to take account of the cost of owner-occupied housing
This is a very weak reed of defiance. The ECB tells us that the cost of owner-occupied housing is now to be estimated in a “stand-alone index” and this should be considered in a wider context of assessing monetary conditions for the next few years. Ultimately by the mid-2020s the ECB foresees that there will be a modified HICP (euro-area CPI) which includes this estimation of owner-occupied housing costs, but this will not be fully operational as a target variable until the late 2020s. Who knows; by then the terrific housing price boom across much of the euro-zone, including prominently Germany and Holland in recent years, might have gone into reverse, meaning the HICP will be reformed in a direction which in fact calls for an even more radical European monetary policy.
The ECB pleads that its new “framework” has become necessary because the problem of the “zero bound” has become so severe. That is, with interest rates already so low, it is assumed the central bank needs new tools to push up price inflation, even with target interest rates already at zero or below zero. This is due, it says, to issues beyond its control. “Structural developments have lowered the equilibrium real rate of interest – decline in productivity growth, demography, and persistently higher demand for safe liquid assets. Hence the incidence and direction of episodes in which nominal policy rates are close to the effective lower bound increased – with the current episode lasting more than 10 years”.
What chutzpah! This alleged problem of “extraordinarily low equilibrium real rates” is a problem of the central bank’s own making. The European sovereign debt and banking crisis of 2010-12, the trigger to initial downward forces on the equilibrium real rate, was itself a consequence of ECB policy through the years 1997-2007. This was highly inflationary, albeit that the symptoms were more sharply visible for much of the time in asset markets than goods and services markets. By aiming for 2 per cent inflation at a time of rapid productivity growth and globalization, also with downward pressure on prices due to increased competition within EMU, the ECB fanned monetary inflation.
“Equilibrium real rates” have remained so low far beyond the crises of 2008-12 and their immediate aftermath precisely because the ECB’s policies have induced and added to economic sclerosis. Its radicalism, characterized by negative interest rates and vast QE operations focussed on bailing out weak sovereigns and banks, has sapped any potential dynamism out of the European economies.
Examples of how the ECB has contributed to economic sclerosis include the fantastic continuing gravy train into Italy which has fortified the status quo there but smothered any creative destruction including winding down of big government and cronyism; the stimulation of a financial engineering boom and more broadly financial speculation in which investors pursue high apparent returns based on camouflaged leverage and other optical illusions rather than potential returns on long-gestation capital spending ; the generation of massive capital exports as interest income famine European investors search out apparently high returns abroad especially in high-risk credit markets and also in the Eldorado of US monopoly capitalism (especially the big five FAAAMs), itself a dead hand throttling economic dynamism globally; the fuelling of a fantastic real estate construction boom most of all in Germany which does not generate productivity growth; creating desperation amongst some households about negative returns on their savings and the ultimate prospects of their pensions becoming cut in the midst of the next financial crisis and so causing them to restrict spending.
Unsound money whether by the Fed or the ECB or the Bank of Japan has produced an apparent low and allegedly (according to the central bank narrative) sub-zero equilibrium interest rate.
Sound money, not a digging in around the present monetary framework, is the answer to the zero rate boundary problem. Author:
Brendan Brown is a founding partner of Macro Hedge Advisors (www.macrohedgeadvisors.com) and senior fellow at Hudson Institute. As an international monetary and financial economist, consultant, and author, his roles have included Head of Economic Research at Mitsubishi UFJ Financial Group. He is also a Senior Fellow of the Mises Institute. He is the author of Europe’s Century of Crises under Dollar Hegemony: A Dialogue on the Global Tyranny of Unsound Money with Philippe Simonnot. His other books include The Case Against 2 Per Cent Inflation (Palgrave, 2018) and he is publisher of “Monetary Scenarios,” Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution.
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