Mr. Draghi's Transmission Mechanism of Monetary Policy

The European Central Bank's Governing Council in its September meeting kept the monetary policy unchanged  leaving  the main refinancing rate at zero, the deposit rate at minus 0.4 per cent and asset purchases at 80 billion euros ($90 billion) a month. Following the familiar pattern of revising down the optimist projections by the IMF and other central banks, the ECB also lowered its growth forecast for 2017, to 1.6 per cent from 1.7 per cent and revised down its inflation forecast for 2016, to 1.2 per cent from 1.3 per cent.

In spite of negative interest rates and quantitative easing, eurozone's growth slowed to 0.3 per cent in the second quarter, from 0.5 per cent  in the first quarter, and headline inflation remained unchanged in August at 0.2 per cent, reflecting in part the lagged effects of oil prices. Furthermore, core, or underlying inflation rate that excludes energy, food, alcohol and tobacco was also lower, at 0.8 per cent in August, as compared to 0.9 per cent in the previous month.

ECB Balance Sheet, Total Assets €3,330,487 mn.

Euro Area Headline Inflation Rate

Euro Area Core Inflation Rate

Inflation has been close to zero since the late 2014 and in fact below 1 per cent since the late 2013. In other words, assuming an upward measurement error,  of the kind discussed by Bernanke and Mishkin (1997) and Camba-Mendez (2003),  of say 0.5 per cent, then one may maintain the hypothesis that eurozone has been very close to a deflationary mode over the past few quarters. The region grew by just 1.6 per cent in 2015 with much of the expansion deriving from the ECB's purchase of more than €1 trillion ($1.1 trillion) of securities so far,  which  has diminished bond yields to abnormally low levels.

While acknowledging that the current negative interest rate introduces challenges for the policy makers, Mr. Draghi suggested that:

Right now the transmission mechanism is really working very well. It's never worked better.

It is very hard to validate this assertion in a market which agents,  in the optimization of their objective  functions, are able to take account of the possible policy actions.  In fact, the transmission mechanism has been disrupted at various critical connections precisely because of this ability and this is why the forecasting models that  central banks are using  are persistently overpredicting the economy's growth rates and why investors are reluctant to invest.

The  ECB’s ability to stimulate aggregate demand by lowering interest rates and devaluing euro has been seriously undermined by the disruption in the transmission mechanism as bond holders prefer to hold on to their bonds despite the fact that an estimated 28 per cent of Eurozone bonds' yields are lower than the deposit rate and  52 per cent of its government bonds  are yielding negative returns. The comparable figures  for German bonds are  66 per cent  and about 85 percent.  Of course, part of the excess demand for bonds stems from the QE's rules that restrict the ECB purchases to  only one third of most bond issues and any bonds yielding less than minus 0.4 per cent.   The rules also restricts the scale of purchases in each country to the size of its economy in the eurozone. For instance in Germany this amounts to  a monthly purchase  of about  €10bn of government debt. Nevertheless, because of excess demand for the German government deb their prices have increased  and more than half  of the country's bonds are now yielding less than the  minus 0.4 per cent which excludes them from the QE.

Mr Draghi maintained that for the time being, the ECB's downward revisions are not substantial enough to warrant a change in policy, and despite the distortionary impacts of the negative interest rates and QE,  he asserted that these policies have been "very effective", since:

While in the previous time we had observed fragmentation and very subdued credit developments, now we can say fragmentation is over and credit is growing constantly.

Of course, credit may be growing constantly, but because of the adverse selection problem this growing credit is not channeled into most productive ventures that could expand the economy's efficient production frontier. As theory envisages the high-risk borrowers are flooding the supply side  of the bond markets while the high quality borrowers are leaving the market because of the increased risk. As a result of getting into this slippery slope  some are now  suggesting the possibility  that ECB, like Bank of Japan, may be forced to purchase stocks. Mr. Draghi  expressed his determination to provide more stimulus if needed and reported that the  bank has asked staff members  to re-evaluate the design of the QE program,  which may hint  to the possibility of a widening of the program to include equities in order to circumvent  the bond shortages.

One has to ponder on the equity-based QE policy's extreme distortionary risks -- e.g.,  how the ECB would  choose among the winners and losers in various sectors and in various countries or would the bank be able to purchase  the promising startups' stocks with high  productivity prospects when the market information is plagued with high levels of noise in this climate of global uncertainty, or would the ECB be focusing on stock purchase  of the Too-Big-To-Fail corporations with low productivity prospects?  The number of such questions would be incredibly large. In any event, eurozone growth is expected to flatline over the next several years like those of many other advanced economies.

 In fact, the ineffectiveness of the ECB's non-conventional policies is already evinced by a recent ECB working paper    that suggests  that in recent years inflation expectations in the eurozone have shown some signs of de-anchoring,  implying  a loss of ECB's credibility due to the lack of information content in its inflation forecasts that has caused the professional forecasters to ignore the bank's inflation targets in their inflation expectations formation. The authors write:

Continuous analysis of de-anchoring risks is crucial in monetary policy, especially in the current low inflation environment. Monetary policy credibility is built gradually over the years, but we cannot rule out the possibility that it may deteriorate quite rapidly. 

When analysing anchoring of inflation expectations, we also need to examine when the inflation target is expected to be reached. Risks of de-anchoring are potentially increasing, if the time when the target will be reached has been postponed in economic agents’ expectations. 

As we have argued in the past, the slowdown of growth and policy ineffectiveness are global phenomena stemming from the current global financial imbalances, currency wars, and a fragile banking system, that are being exacerbated by the QEs and other unconventional policies. The fact that German and French business sentiment fell unexpectedly in August, especially among manufacturers, is another sign of the ECB's loss of credibility to deal with this global predicament.  Even the ECB's resort  to the currency war  has resulted in an upward pressure on euro due to generating a current account surplus that cannot be offset by outflow of the scarce capital from the region, due to the fragility of its banking system.

Euro Area Productivity

As the above chart indicates, the eurozone productivity growth  has slowed markedly over the post-recession period. The ever-so-slight  positive slope in the trend productivity of the recent years  has been basically concentrated in countries like France and Italy which have experienced a rise in their unemployment rates, indicating that the recent unemployeds in these countries have been mostly among the least productive labourers.  

In contrast, productivity growth has been stagnating in Germany,  a fully-employed economy with balanced public finances and a surging current account surplus of 9 percent of GDP.  Registering 1.8 per cent annual growth rate  in the first half of this year, German economy is running almost one percentage point above its potential and is attracting  inflow of funds from the low productivity countries. German GDP growth in the second quarter was tepid 0.4 per cent, down from a 0.7 per cent  in the first quarter and its business investment exhibiting the same wait-and-see pattern as the rest of the advanced economies.

Despite this anaemic productivity growth Mr. Draghi's advice to Germany, an export-reliant country, is that it must increase its unit labour cost by allowing wages to increase. He suggested that:

Countries who have fiscal space should use it. Germany has fiscal space.

But in today's circumstances  Germany's fiscal space has to be used to increase the productivity of eurozone's pripheries, otherwise it will be adding to imbalances.  However, this would imply a centrally planned model which would be destined to failure.

German Productivity

French Productivity

Italian Productivity

German Unemployment rate

French Unemployment Rate

Italian Unemployment Rate

In August 2015 we argued here in this forum that:

Consistent with Ben Bernanke’s option price of waiting it would be quite rational for businesses to postpone their strategic investment plans at times of currency wars and global volatility, and focus instead on their contingent capacity limits. Thus, business surveys instead of picking up reports of capacity utilization rates relative to the long term capacity associated with the firm’s minimum long-term average costs would detect signals of capacity tightening due to delays in implementation of irreversible phases of investment. This observation can also be validated by indicators such as investment profile and productivity growth. Note that productivity growth — defined as the rate of change of output minus rate of change of hour worked — will rise when investors invest to expand the production possibility frontier which usually would  reduce their cost structure through adoption of new innovative technologies.

Last February we argued here that:

It appears that central banks have forgotten a number of basic macroeconomic facts; 

i. The liquidity demand will become inelastic around the potential output, and potential output itself shrinks when there is no capital formation and plenty of uncertainty. Moreover, reducing the interest rate cannot affect the growth rate of real output when aggregate demand becomes insensitive towards changes in the policy rate. The conventional theory suggests that the impact of increased liquidity should be translated in higher inflation rates. However, this could be the case if and only if the newly created liquidity can enter into the markets, via consumption and investment which is not the case in today’s economic environment. One can argue that in today’s economy either central Banks have lost their ability to create liquidity, or to the extent that they are able to do so firms’ change of behaviour has offset it. In other words the liquidity created by central banks is hoarded by firms. Businesses are not investing, because they do not see a sustained level of increased demand, and negative interest rates cannot force them to invest because they have invented new instruments and innovative tactics in order to hoard liquidity.

ii. If central banks are aiming at a currency war, to increase their market share of exports, they must have forgotten that these wars worsen the already highly toxic trade environment. In fact, this is the classic case of ‘fallacy of composition”

It appears that in his Brussels Economic Forum lecture, on June 2016,  Mr. Draghi was agreeing  with that kind of analysis  and correctly acknowledging that;

There is also emerging evidence that growing below potential for too long can erode that potential through its effect on productivity growth. When uncertainty is high, a “wait-and-see” attitude can cause the most productive firms not to expand as much as they would otherwise. (...) The cost of delay, then, is that labour and productivity suffer, and the output gap closes in the “wrong way” – instead of output rising towards potential, it is potential that falls towards current output.

The same idea of wait-and-see has been supported by John Cryan, the chief executive of Deutsche Bank, in a recent commentary published in Germany's Handelsblatt newspaper stating that:

"companies are holding back due to the ongoing uncertainty with investments and are rarely requesting loans."

This is  a clear sign of a disruption in transmission mechanism. Europe is sliding fast toward a deep recession.