Over the past several months, the European Central Bank has continuously claimed that its monetary stance is appropriately accommodative. At its last meeting on August 2, the ECB decided against rate cuts and other actions that would have eased its monetary stance. This is discouraging, given that the ECB recently acknowledged challenges with the transmission mechanism of its monetary policies, especially with respect to Italy and Spain.
While one could argue that the ECB’s hints at future actions should help alleviate fears of default risks in Europe’s periphery, the ECB could have eased monetary conditions further with a variety of additional measures. Indeed, just prior to the ECB’s recent meeting, many in the financial markets expected some combination of further cuts in the main policy rate, easier collateral requirements or other actions to expand the ECB’s balance sheet. For instance, it could implement asset purchases or special lending programs (long-term refinancing operations – LTRO’s, etc.). The ECB declined to take any action.
The ECB is certainly not alone among the developed world’s central banks in claiming to have implemented policies it considers extraordinarily accommodative. In fact, in addition to setting record low policy rates, many of the developed world’s central banks have also adopted non-standard measures to further ease conditions. However, the ECB is unique in maintaining a high policy rate (currently 75 bps) compared to other central banks despite Europe’s recessionary levels of economic activity. While the policy rate is only one measure of its monetary stance, it is fair to ask if the ECB really is as accommodative as other central banks and whether it should do more.
Looking at very broad measures of financial conditions, it is easy to identify the ECB as a central bank that is relatively tight (see figure 1 on financial conditions).
While the ECB has managed to cut the policy rate low enough to create negative real rates, it is important to note that the price of money has become less relevant than the quantity of money released into the system in determining relative accommodativeness. This is particularly true given the fall in the velocity of money over the past decade (see figure 2 on velocity).
Looking at measures of the quantity of money and its transmission into the real economy reveals that ECB policy is quite tight. Both real narrow money growth (M1) and real broad money growth (M3) are close to their lowest levels since the euro’s inception and barely positive in absolute terms (see figure 3).
Low velocity and the absence of real growth in money supply do not provide a monetary policy backdrop that is conducive to bringing the eurozone back to a sustainable growth path. Growth hardly stands a chance under this scenario as the relationship between base money growth and economic activity is particularly strong in the eurozone (as shown below in figure 4).
Other leading and coincident non-monetary indicators, like the IFO Business Expectations and eurozone Manufacturing Purchasing Manager Index, confirm that Europe faces the potential for further deceleration in economic activity that would warrant additional monetary easing. As it stands, low economic growth rates are aggravating the impact of fiscal austerity as well as the crises arising from poor sovereign debt dynamics. Relatively tight monetary policy would perhaps be understandable if the eurozone were threatened by inflation. However, inflation is low and falling in the eurozone owing to rising unemployment, low capacity utilisation and a large gap between current output and potential output.
And even if the ECB pursued further traditional measures (e.g., rate cuts) and supplemented them with non-standard liquidity and balance sheet expansion, the task of jump-starting growth would not be easy. The eurozone is saddled with deep structural problems and several non-core countries are operating amid a liquidity trap/balance sheet recession, in which monetary policy is being undermined by financial sector deleveraging. Rather than obviating the need for more easing, this should spur attempts to accelerate all forms of monetary accommodation before more long-lasting damage is done to the economy.
Overall, it appears the ECB may be playing a game of chicken with European policymakers by deliberately holding back on much-needed additional easing to maintain pressure on them to continue to implement structural reforms and re-work the eurozone’s design flaws and governance structure. If true, this is a dangerous strategy in light of the experience of 2008 and 2011 when the ECB made ill-timed mistakes, tightening monetary policy even as the economic outlook deteriorated.
Whether the motives are economic or political, we believe the ECB’s current monetary policy stance is overly restrictive on an absolute and relative basis. Even with the ECB hinting at new action in the coming weeks and months, it remains to be seen how effective and long-lasting the benefits will be. In the meantime, it is our view that the eurozone and global economic climate continues to be constrained by the ECB’s inappropriately tight monetary policy stance.
Scott A Mather is a managing director in Pimco's Newport Beach office and head of global portfolio management. Dirk A Jeschke is a portfolio manager in Pimco's Newport Beach office. Reprinted with permission. All rights reserved.