Originally published on June 11, 2014
The biggest, and most highly anticipated, economics news story of the past two weeks was definitely the European Central Bank's press conference, which took place on Thursday, June 05, 2014. Officials at the European Central Bank (ECB), mainly Mario Draghi (the ECB's President), have been hinting for quite a while that the ECB was ready and willing to enact further accommodative monetary policy measures if the inflation rate in the Eurozone continued to decline. Further stimulus measures seemed almost guaranteed when, on June 2nd, the Federal Statistical Office of Germany (Destatis) released a preliminary CPI (m/m) reading of -0.1% for the month of May. The preliminary CPI report, which indicated that "annual inflation in Europe's largest economy likely slowed in May," was just the latest indication that inflation in the Eurozone is getting perilously low and Germany's preliminary CPI reading "probably pushing down the broader euro zone rate" while "raising pressure on the European Central Bank to act" during its next meeting.
Just how much pressure did it put on the ECB? Well, due to the fact that it is Europe's largest economy, Germany's economic results are extremely important, and are looked at quite closely by ECB officials. In fact, Germany's economic results are so important that they saved the entire Eurozone from contracting in the most recent quarter. As you all probably know, "the European Union's Statistics Office estimated that the economy of the 18 countries sharing the euro expanded only 0.2 percent on the quarter in the first three months of the year, rather than the 0.4 percent growth expected by economists." That growth figure, which is extremely bad considering the fact that economies around the world want to expand quickly as they recover from a financial crisis, would have been even worse if Germany hadn't "posted strong growth in the first quarter of the year." Germany's "strong growth,"which is only "strong" if you compare it to other countries in the Eurozone, stood "in stark contrast to France, which stagnated and to Italy, the third largest economy, which contracted."
Germany's GDP growth of 0.8% far outperformed that of major member states in the Eurozone, however the boost that Germany gave did not allow the Eurozone to expand at as fast a rate as other advanced economies. In fact, the Eurozone has recovered, from the recent financial crisis, at a much slower rate than many of its peers.
This can be seen when one looks at the following graph:
The Eurozone is also lagging behind its peers when it comes to recovering from the extremely low inflation rates all the developed economies experienced after the financial crisis and, while its GDP results helped boost the Eurozone's overall performance, Germany's extremely weak preliminary CPI reading (-0.1%) almost certainly hurt the Eurozone's annualized CPI growth figure. The Eurozone released a CPI Flash Estimate (y/y) growth rate of only 0.5%, the day after Germany released its preliminary CPI report, which missed analysts' expectations for a 0.7% growth rate. This annualized CPI Flash Estimate tied the one for March, 2014, as the lowest CPI growth rate since October, 2009. Germany's inflation numbers are very important to the Eurozone, because until recently they were higher than those of the Eurozone itself, so it is reasonable to expect that if Germany continues to experience a low inflation rate it would have a significant impact on inflation in the Eurozone as a whole.
To illustrate this point, Germany's annualized inflation numbers can be seen compared to those of the Eurozone, Spain, and Italy in the following graph:
The ECB was forced to act, and it did so quite deliberately. ECB President Draghi announced, in the ECB's press conference on June 5th, that the ECB was going to combat low inflation by cutting the minimum bid rate to 0.15% (from 0.25%), pushing the deposit rate into negative territory (to -0.1% from 0%), and by introducing a number of "additional stimulus measures."
In a Bloomberg article entitled "ECB's Big Bang Is Impressive, but More Is Needed," Mohamed A. El-Erian (chief economic adviser at Allianz SE) stated that the entire "stimulus package" is designed to ease "…monetary and credit conditions not only through the negative deposit rate and a lower lending rate, but also by putting an end to its weekly absorption of money in circulation (a process called sterilization) and providing better credit access for banks that lend to businesses and consumers."
The question on everyone's mind is: Will this be enough?
In my opinion, the answer to that question is no.
Too Little Too Late
The ECB made history when it moved its deposit rate into negative territory, but (in my opinion) making history wasn't enough.
Why The Policy Shift Was Too Little
The Federal Reserve, the Bank of England, the European Central Bank, and (later on) the Bank of Japan all enacted emergency stimulus measures to fight off deflation, as the recent financial crisis was drawing to a close (the U.S., Japan, and the Eurozone all experienced deflation at the end of the financial crisis, but England did not), and since then their policies to fight low inflation levels have varied.
Without going into lots of long exhausting detail about the specifics of the stimulus packages enacted by each central bank, I will simply classify them as follows:
The United States of America - Federal Reserve System: Very accommodative stimulus package. Employs a stimulus program known as Quantitative Easing (QE). The program was first launched in late 2008 and later went through three stages, known as QE1, QE2, and QE3. The program started at $600 billion (QE1) and then grew to $85 a month (QE3). The Fed is now unwinding this stimulus program at a rate of $10 billion per month. The Federal Open Market Committee (FOMC) is the committee within the Federal Reserve System that is in charge of these operations.
The United Kingdom - Bank of England: Fairly accommodative stimulus package, but less accommodative than the one enacted by the Federal Reserve. Unlike the other countries mentioned here, the United Kingdom did not have to dig itself out of deflation territory after the 2008 financial crisis (the inflation rate in the United Kingdom dropped to a "reasonable" annualized rate of 1.1% in the wake of the financial crisis). The BOE began purchasing assets in March, 2009, and since July, 2012, the total amount of assets that the central bank has purchased has remained at 375B (euros). As of April, 2014, the annualized inflation rate in the UK is 1.8%. The Monetary Policy Committee is the committee within the Bank of England that is in charge of these operations.
Japan - Bank of Japan: Extremely aggressive stimulus package. "The first round of QE by the BOJ started on March 19th, 2001," and it was one of the first (if not the first) major central banks to experiment with quantitative easing. On "Thursday 4 April 2013," the BOJ "unleash[ed] a massive programme of quantitative easing- worth $1.4tn (£923bn) that [doubled] the country's money supply."
The Eurozone -European Central Bank: Extremely light (in comparison to the other three) stimulus package.
Before The Recent Policy Change: The ECB mainly focused on keeping interest rates low, by buying government backed bonds. The ECB realized that this was no longer effective (obviously) so they decided to make some changes, and follow in the footsteps of other centrals banks (the three described above).
Recent Policy Change:
- Cut the minimum bid rate to 0.15% (from 0.25%)
- Slashed deposit rate into negative territory (to -0.1% from 0%)
- "Additional measures" (see below)
Zerohedge.com has a great article on the "additional measures" that the ECB will employ to stimulate growth and the Eurozone's inflation rate. Below is a quote of all the "additional measures" that are mentioned in the article.
- "Draghi Unveils Package Of Targeted LTROS, Work To Prepare QE
- Draghi Says Initial Size Of Targeted LTRO Plan Is 400BLN Euros
- ECB Extends Fixed Rate Full Allotment, Suspends SMP Sterilizing
- Draghi Says Package Includes Preparations For ABS Purchases."
The ECB's new stimulus package may sound great, and it really is a big step up in terms of "easy money," but it should be clear after reading the descriptions of the different stimulus packages above that it isn't as extreme as those enacted by other central banks.
I'm sure you realized the ECB's new stimulus package is now bigger than the one that was employed by the BOE, but what I'm sure you also realized (after reading all of the above information) that the United Kingdom is much better off economy-wise than the Eurozone.
The Eurozone is experiencing a much slower annualized GDP growth rate, and a much lower inflation rate, than the other three major economies mentioned above.
The Zero Hedge article included the following ironic commentary on the Eurozone's GDP growth rate and inflation rate:
Speaking of growth, we get the usual V-shaped yoyo: cut of 2014, while boosting 2015 and 2016. Guess the ECB does not anticipate snow or Easter next year:
ECB SEES 2014 GDP GROWTH OF 1% VS. 1.2%
ECB SEES 2015 GDP GROWTH OF 1.7% VS. 1.5%
ECB SEES 2016 GDP GROWTH OF 1.8% VS. 1.8%
Curiously this is happening as inflation is revised lower across the board relative to prior forecasts:
- ECB SEES 2014 INFLATION AT 0.7% VS. 1%
- ECB SEES 2015 INFLATION AT 1.1% VS. 1.3%
- ECB SEES 2016 INFLATION AT 1.4% VS. 1.5%" (Zerohedge.com)
After looking at all of the information that I have included above, I believe that the ECB should have employed a much more aggressive stimulus package than the one it is currently enacting. That is why I believe that the ECB's stimulus measures were TOO LITTLE.
Why The Policy Shift Was Too Late
After experiencing a short period of deflation at the end of 2009, the Eurozone's inflation rate climbed quickly to 3% by late 2011 and then began to decline steadily from there. While other central banks such as the Bank of England, the Bank of Japan, and the Federal Reserve, have pursued "wholesale asset purchases…with their quantitative easing programs" over the past five years, the ECB has refrained from doing so. Now, with "preparations for ABS purchases" as part of the ECB's "additional stimulus measures," it appears as though ECB officials are now finally considering employing something along the lines of a QE program in the not-so-distant future.
What would it take for the ECB to enact a QE program? It would probably take an even lower inflation rate, or deflation (an inflation rate below zero), for the ECB to consider a QE program. However, if the inflation rate of the Eurozone continues to decline, which will almost certainly happen if the inflation rate in Germany declines further, deflation might not be that far away. What allowed the Eurozone's inflation rate to get so low? Well, sometimes it's better to go along with the pack than to be the odd man out, and the ECB was definitely the odd man out when it came to enacting very accommodative monetary policies shortly after the financial crisis.
Although it wasn't the first central bank to attempt a QE program, the Federal Reserve System was the first one to significantly devalue its currency by injecting huge amounts of money into the economy through its QE stimulus program, which it began in late 2008. This sparked a chain reaction as central banks around the world raced to devalue their own currencies, so that their economies would suffer from a declining inflation rate, because a declining US Dollar would cause foreign currencies to have a higher value in comparison to the dollar (a higher currency value compared to the US dollar would hurt those countries'exports). The United Kingdom quickly followed suit and, in "March 2009," the Monetary Policy Committee (the committee in the BOE responsible for monetary policy) began its own QE program when it announced that it had "decided to undertake a series of asset purchases." Although "the first round of QE by the BOJ started on March 19th, 2001," the BOJ needed to significantly ramp up its asset purchases in order to catch up to the other two central banks, and win its long fight with deflation. On "Thursday 4 April 2013," the BOJ "unleash[ed] a massive programme of quantitative easing - worth $1.4tn (£923bn) that [doubled] the country's money supply."
It is easy to see what effect those QE programs had on each country's currency.
Look at the chart below, which is a chart of UUP (an ETF that tracks the value of the US Dollar), and after late 2008 you will be able to see the effect the Federal Reserve System's QE program had on the US Dollar.
Look at the chart below, which is a chart of the PHLX British Pound Index (roughly the exact value of the GBP/USD currency pair), and after mid-2009 you will be able to see the effect the Bank of England's QE program had on the British Pound. Also note how the value of the British Pound shot up (after declining a bit first) once the BOE stopped purchasing more assets in mid-2012.
Look at the chart below, which is a chart of the PHLX Japanese Yen Index (roughly the exact value of the YEN/USD currency pair), and after April 2013 you will be able to see the effect of the Bank of Japan's QE program on the Japanese Yen. It doesn't get more obvious than that.
Those QE stimulus programs largely achieved their objectives (their inflation objectives at least!), and all three of those central banks successfully devalued their currencies, which saved them from experiencing deflation. The QE programs also (most likely) stimulated growth in those three economies, through maintaining low short-term (and long-term) interest rates, and helped decrease the amount of systematic risk possessed by large (non-government owned) banks. Although the long-term effects of those huge stimulus measures are unknown, we can definitely tell that the three central banks were able to negate the risk of deflation.
What those central banks did worked, in terms of devaluing their currencies, and what the ECB chose to do (refrain from more aggressive stimulus measures) did not work. It is because of that that I declare that the ECB was too late when it came out with its own, more aggressive, stimulus measures recently. It is well known that the policies that central banks enact affect their respective countries with a lag, something I learned while taking a freshman Macroeconomics class at Boston College, so I can definitively say that the ECB is way behind the curve when it comes to devaluing its currency.
Look at the chart below, which is a chart of the PHLX Euro Index (roughly the exact value of the EUR/USD currency pair), and you will be able to see how strong the currency has remained over roughly the past four years (and more specifically how strong it has been over the past two years).
(click to enlarge)
What Will The Effect Be On U.S. Stock Markets?
First, I would like to start off by saying that I am just an enthusiastic sophomore (will be a sophomore next fall) that is very interested in economics and the stock market. I have only taken one macroeconomics class and, while I've spent numerous hours of my free time researching different topics related to economics, I still have a lot more to learn. Obviously I am not an expert, so I do not presume to know (with any degree of certainty) what effect the ECB's stimulus package will have on the stock market. My inability to give you all a concrete prediction in this regard does not bother me, because professional economists are still divided when it comes to how monetary stimulus packages affect the stock market and anyone who claims to know exactly what effect the ECB's stimulus package will have probably cannot be trusted.
With all of that being said, the only thing that I can do is say what I think and what I've noticed from looking at historical trends.
As mentioned above, I think that the ECB's monetary stimulus measures were too little and too late. Therefore, I do not believe that the ECB will be able to weaken the Euro as effectively as other the central banks of other countries were able to weaken their own currencies. This also coincides with my belief that the US Dollar may have one final rally left in it before it begins to decline for a long time. I mentioned this in the last issue of my newsletter, where I predicted (albeit briefly) that the US Dollar will rally for the next 3-6 months, and I still believe this to be true.
Unfortunately, this article is already too long for me to get into too much in-depth analysis on the US Dollar, but I wanted to state my prediction here regardless. I believe that the US Dollar will rally while many people continue to believe that the Euro is going to depreciate in value due to the ECB's stimulus measures (this is just a short-term speculative driver for the Euro), and while people continue to anticipate that the Federal Reserve will unwind its QE program and raise interest rates shortly after. That is all I will say on the topic (why I believe the US Dollar is going to rise for next 3-6 months) in this issue, but look forward to me talking about it soon!
The US Dollar, over the long-term, has had a negative correlation to the S&P 500. Therefore, a rising US Dollar could mean a fall in the S&P 500. You can read more about the relationship between the Dollar and the S&P 500 in this article.