ECB Conventional Monetary Policy Is Dead, Long Live Unconventional Monetary Policy

by: Adam Whitehead


Recession risk rose swiftly in late Q1 2018.

European economic reform is being overwhelmed by national political agendas and the economic deceleration of Q1 2018.

The ECB’s Villeroy de Galhau pencils in reinserting QE extension into guidance if required in the future.

The ECB Executive Board and Governing Council agree that QE should be tapered rather than abruptly terminated.

The ECB has nothing other than unconventional monetary policy in its toolbox at this point in time.

(Source: IMK)

As what the ECB has characterized as temporary economic softness in Q1/2018 threatened the schedule for the beginning of the end of Quantitative Easing, the ECB Vice President casually informed that QE is the only game in town in the event that the slowdown becomes a permanent one. The Eurozone economy has fundamentally changed and there is no going back to the cosy old world of conventional monetary policy.

(Source: Econoday)

The last report observed that the Eurozone had been through a soft patch in Q1/2018 that may in fact be a tipping point. A new data point out of Germany, the supposed driver of the Eurozone, suggests that a tipping point is more visible. The Macroeconomic Policy Institute (IMK) in Dusseldorf recently published its recession probability tracker, which is now back at levels last seen in 2016. Significantly the indicator spiked this month, after bottoming at the end of 2017. Admittedly the recession probability still remains small at only 30%, but the rapid deterioration in conditions should cause even the Bundesbank to ponder the fate of the German economy. The main culprit is the volatility in financial markets knocking on to sentiment in the real economy in Q1 of this year. The weak IMK data was then confirmed by the April ZEW survey. Current conditions in this report have weakened slightly, but future expectations have fallen off a cliff.

Should this German weakness become more permanent, then the IMK will have to revise its positive outlook for the year lower. Rhetoric from ECB Hawks may also have to be softened in the meantime, until either the slowdown is confirmed or denied by the data at which point they can either change their rhetoric meaningfully or turn up the Hawkish invective again.

ECB Governing Council member Francois Villeroy de Galhau was the first Eurozone central banker to officially address the weakening data. He did so with surprising speed. Whilst acknowledging the softening, he does not believe that it is material enough to change the ECB’s outlook. He also tried to frame perceptions that his view is widely held by his colleagues, so that consensus remains unchanged. He did however say that the end of QE could move out from September to December, but opined that this is not a significant change. There was also a hint and a nudge from him, that the language to extend QE if conditions demand may need to go back into the official guidance statement. The conditionality for the reinsertion of this clause was set by him as “possible cumulative risks scenario, the likelihood of which has increased recently: an adverse loop of protectionist threats, unfavorable exchange-rate movements, and abrupt financial-markets corrections.”

So severe and unexpected has the Q1/2018 been, that even the Bundesbank President has had to adjust his rhetoric. This should be no surprise, since Germany has slowed down more than its neighbors. By way of rhetorical adjustment, Bundesbank President Jens Weidmann opined that the tailwind of “air is getting thinner” even though “we (Bundesbank) definitely can’t detect any reason to see an economic turning point now.” Weidmann should therefore in principle support the ECB decision not to end the current phase of QE prematurely. Since he detects no reversal, he will not support a re-insertion of language saying that the ECB will ease again however.

(Source: Econoday)

Weidmann’s change of rhetoric is not however reflective of his colleagues. The Bundesbank itself still predicts a boom to occur in 2018. In its latest forecast it writes off the recent weakness to a combination of industrial strikes, flu and cold weather, the net effects of which will soon dissipate. Ifo economist Klaus Wohlrabe, like his peers at the ECB, refused to call the fifth declining Ifo report in a row anything more than a normalization back to underlying trend. The German finance ministry’s response has been to lower its growth forecast for 2018 slightly from 2.4% to 2.3%, hardly a change at all. This is all well and good but the Germans seem incapable of telling the difference between weather affected and normalization, which undermines the objectivity and credibility surrounding their pronouncements. It seems more a case of German with a hammer only being able to see nails to hit aka Cognitive Bias.

In fairness, it is not only the Germans who are blinkered. Even Governing Council member Francois Villeroy de Galhau believes that the slowdown may be temporary, although he was careful not to mix the potential causes.

Going into the latest Governing Council meeting, in response to the softer economic data, the general tone of ECB guidance changed to a posture of slowing down the normalization process rather than abandoning it. ECB Governing Council member Jan Smets followed the rhetorical process of slowing down the normalization by cautioning that weak inflation is still a concern.

Governing Council member Ardo Hansson seems to be getting ahead of the curve with his latest guidance. According to him: "We (ECB) are on a course where monetary policy has recently been moderately normalised - mainly on asset purchases". He believes that this normalisation has been achieved through the process by which “communication has been moderately changed as there is more confidence on changes in inflation.” The hyperbole surrounding the ECB dropping the commitment to ease further if conditions weaken has clearly affected Hansson, or at least he would have us believe this.

(Source: Bloomberg)

Hansson may also be alluding to the fact that the ECB has scaled back the Qualitative Easing process in which it has been purchasing corporate bonds. The smoothed incoming data that tracks its purchases shows a clear deceleration in the pace of corporate bond buying.

Hansson is also anticipating the future steps of his Governing Council colleagues, who remain more inert than he is in pivoting towards the normalization. The Executive Board of the ECB has accepted the eventuality of the normalization in principle. For board member Benoit Coeure, the softness in Q1 is not a reversal of the underlying strong growth trend. Board member Yves Mersch confirmed this acceptance along with a warning not to swiftly and abruptly pivot to a full blown normalization however. His position and that of the Board is characterized by his latest comments, in which he said that “more resilience will follow eventually. Still, patience and persistence with respect to our monetary policy is required.” Mersch employed the double negative technique, in order not to frame the inflation picture as requiring tighter monetary policy per se. In his view, inflation has not fallen as much as was initially expected by the ECB so far this year. Going forward, it is his view that developments of inflation will ultimately govern how monetary policy changes unfold. Evidently the Executive Board would like to see a tapered ending of QE.

Responding with alacrity, on behalf of the Governing Council, Vitas Vasiliauskas signaled that the views of the Executive Board are well understood and accepted. In his view progress on growth and inflation “has increased my (his) confidence that it is time to transition from the asset purchase program. However, the closure of the program should not be abrupt.”

Despite the latest ECB decision to leave policy unchanged, Mario Draghi’s commentary at his press conference was right in line with his colleagues on the Executive Board and Governing Council. He attributed the softness in Q1 to temporary factors, which do not undermine the economic strength or accretion towards the inflation target significantly enough to change the normalization schedule. He did signal that further Euro strength from here may change his perspective, even though it was not discussed at the latest meeting. Leading up to the meeting there had been some raised expectations that the normalization would get debated and officially minuted. Governing Council member Ewald Nowotny had been pushing for this scheduled debate. As it transpired, no such debate took place and Nowotny was ostracized, especially given the weak economic data in Q1 which made his militancy potentially dangerous. Draghi therefore used Nowotny’s insubordination to tighten his grip on communications.

The supporting voice of Vice President Vitor Constancio was as illuminating as Draghi’s on this occasion. He offered an interesting postscript to world beyond the normalization. In his opinion, there has been a fundamental change in the credit markets since QE became an accepted policy tool. The transmission process from central bank monetary policy through the capital markets and ultimately to the real economy has therefore changed. This means that it is highly unlikely that the ECB can ever return to a process of conventional monetary policy after QE has ended and also that it will reach for unconventional monetary policy tools swiftly in the face of another economic slowdown. Conventional monetary policy is therefore dead on arrival.

(Source: ECB)

Of more interest too, was the publication of the latest ECB growth and inflation forecasts. The growth target for this year was raised, whilst inflation was left unchanged. If Yves Mersch’s inflation conditionality governing the normalization is to be taken at face value, the ECB will be predictably underwhelming in its gradual move to normalization this year. The longer term forecasts, for a softening of both the inflation and growth outlook, from 2019 and beyond also suggests that the underwhelming normalization will have a very soft taper component. Real GDP of 0.5% in 2019 which then goes to minus 0.1% in 2020 may even prompt Vitor Constancio’s forecast revisit of further unconventional monetary stimulus to get factored back into price discovery in Eurozone capital markets.

(Source: Seeking Alpha)

The last report continued to track the emerging European alliance of France and the UK in the Brexit frame of reference. The recent air strikes on Syria illustrate how this alliance has a global dimension also. Indeed, President Macron widely took credit on behalf of himself and Theresa May, for persuading President Trump to remain engaged and embedded in Syria. Russia is the common denominator in all the cases that highlight this alliance.

(Source: Seeking Alpha)

The last report also outlined the emerging new pro-EU party taking shape within Britain in order to nullify and/or reverse the Brexit decision.

(Source: The Guardian)

Potential founders of this party recently emerged in the form of a cross party alliance with the same stated aims. To build political capital and momentum, a new ComRes poll revealed that nearly 50% of Brits now want a new centrist party. This new party may find a curious alliance with the un-elected House of Lords in the parliament. The Lords defeated the government’s position to leave the Customs Union after Brexit. The defeat of the government is symbolic; however, it threatens the legitimacy of the decision to leave the Customs Union and may lead to a forced change on this position. The cross party symmetry in the Lords with the emerging new party in the Commons, also clearly demonstrates that there is motive and opportunity to create a new bloc in both houses of parliament.

(Source: Bank of England)

There are signals that the Cabinet is already considering reversing the decision to quit the Customs Union, but is fearful of the acrimony and divisions that this will create within the Conservative Party. In practice, the schism threat may be a non-event. Ardent Brexiteer Liam Fox signaled that his side is ready to fold. It would seem that his faction has been bought out by the EU’s willingness to grant concessions to the British service sector in such a way that the position of London as a global financial center will be maintained post Brexit. He may also have seen the traction of the new fledgling centrist party and decided that it is the time to be on the right side of political history.

According to the Bank of England, Britain is currently drowning in a position of productivity stagnation last seen as the Empire headed towards terminal decline and two World Wars. The historical parallel cannot be lost on the Conservative Government as it prepares to face a world of nations outside of the EU in which Britain’s future is economically challenged. The seductive logic is that as a global financial center, Britain’s post Brexit service industry balance of payments surplus will be maintained and boosted further. As a financial center, Britain will therefore be well placed to maintain its global presence and significance in a post-Brexit global economy. As usual, the Europeans have understood that government policy making in Britain is always done for the City despite what the voters demand. No amount of provincial roadshows by the Bank of England, or noises about the mythical Northern Powerhouse, should convince the credulous observer that anything has changed in Britain since the Brexit vote.

Scenting a capitulation by the Cabinet and self-destruction of the Conservative Party, the EU then conceded further ground on the Customs Union. In the latest proposed concessions, Britain will be offered a sweeter deal than Turkey gets, in which it will also be able to offer some input into the decision making process governing the Customs Union. It now remains for Theresa May to use her dwindling credibility to sell the new Customs Union deal to her party in a way that does not lead to a split. The EU on the other hand now openly plays to the gallery of Remainers in Britain, sensing that they now have the initiative.

Unfortunately for the fledgling party, British industry is not behind it ….. yet. The last report explained the extreme risk aversion of British business. Based on its reaction, to the new party and second referendum momentum, Britain Inc has already set out its stall and its balance sheet for Brexit. This positioning is a direct bet that the Pound Sterling will fall and provide a tailwind to Britain Inc once Brexit is over. Having seen the rally in Sterling since Brexit odds have been widening, Britain Inc is offside on its positioning and therefore will not entertain a second referendum or a new party. Britain Inc could however be bought off if a default position of Custom’s Union membership plus Brexit were delivered.

Austria was noted in the last report as being a notable absentee from the Eurozone coalition of the willing, who supported Britain by imposing sanctions on Russia in reaction to the poisoned Russian spy on British soil. This aloof Austrian position should be put into the context of the economic reality facing its banking system’s exposure to Eastern Europe within the wider context of Europe’s non-performing loan (NPL) crisis. Austrian banks’ exposure to Eastern Europe was a highlight of the Eurozone’s experience during the Credit Crunch. Austrian banks are currently trying to persuade eastern host nation governments to oblige with their taxpayer’s money funded bailouts in the event of the next Credit Crunch. The less favored alternative is for Austrian banks to make their eastern subsidiaries full branches and then seek Austrian taxpayer funds for any bailouts.

The procrastination from Austria on Eurozone economic initiatives, in favor of focusing on the needs of its own banking sector, highlights the fact that Europe has still not got its act together on deeper economic union. It also shows that, as capital markets volatility discounts the widening deterioration of relations with Eastern Europe and Russia, the risk of a real economic catalyst to trigger another Credit Crunch is also rising. Once again, the ECB will be in no mood to rush to normalize in this situation.

Germany has also been strangely silent on Brexit, Russia and Syria of late. Its absence from the global leadership podium owes much to the fact that it is now a traditional weak coalition democracy. The SPD coalition faction would love to steam ahead with bold Eurozone and global initiatives in partnership with President Macron. The CDU faction understands the iron law of the German democratic process, which prevents the SPD’s enthusiasm from turning into policy action. The Bundestag will have to vote on a Brexit deal and any other changes that lead to deeper Eurozone fiscal and economic integration. There is a strong theme of Populism in Germany, which is averse to deeper Eurozone integration without real fiscal rules and limitations on its member states. This theme transcends all party loyalties.

German absence from the global great game, being played out in Britain, Russia and Syria, simply reflects the undemocratic dimensions of current said rules of engagement. Ultimately, national voters in all nations involved will get to opine and vote on the decisions taken in the great game. At this point the game will revert from headlines and drama to the mundane practicalities of the parliamentary process in all the nations involved. At such a point, momentum to do anything will be lost and political inertia will set in.

As the Eurozone collectively degenerates into a morass of national interests the inertia to deliver reforms and deeper economic integration is becoming overwhelming. Klaus Regling the head of the European Stability Mechanism recently offered an ominous warning, which signals that the momentum established by President Macron’s presidential victory is rapidly decelerating.

The case of Italy highlights the conflicted agendas which are stalling reform and deeper Eurozone integration perfectly. Italian households hold the bulk of Italian bank debt. Italian banks also have the lion’s share of the non-performing loan (NPL) problems in the Eurozone. The NPL issue at the Eurozone level is therefore the antithesis of the domestic Italian position. Cleaning up the Italian NPL’s would mean that the small investors take a hit, which would then have massive Populist implications.

The Northern Europeans will not consider any bailout of the Italian banking system with their funds, which is why the Eurozone blanket bank deposit guarantee initiative has stalled. As German Finance Minister Olaf Scholz recently opined: “With regard to the banking union, when we have managed to effectively reduce risk we can begin talking about further risk sharing.” It should be noted that Scholz is from the party that is supposed to be pro-EU, so one can imagine what the conservative members of the coalition think. Neither the Northern Europeans nor the Italians will shift their position, so progress towards deeper economic integration is stalled in practical terms.

Signalling that the national elected governments have won and that economic reform has lost, the ECB hinted that it is going to give up on trying to enforce protocols for the banks to deal with their legacy NPL’s. In order that no side appears to lose face, whilst the reform process in general loses all credibility, the ECB also hinted that it will use the excuse that the economic recovery has significantly reduced the threats from NPL’s.

Single Resolution Board chair Elke Koenig then signaled that her agency has effectively had its bank regulatory powers limited henceforth, with the words of resignation that “our fund will never be sufficient to be the sole answer and this means an important role for central banks, in particular for the European Central Bank.” In practice what this means is that, when the next recession triggers a banking crisis, the ECB will step in Fed-style and do whatever it takes to save the banks. This effective ECB put should now embolden European bankers to go back to their ancient corrupt practices of credit creation.

ECB Executive Board member Benoit Coeure then outlined the terms and conditions of the ECB put to save the banking system. This is in effect a self-fulfilling tautology that once again legally covers all the bases. The ECB will not provide emergency liquidity when a bank is going to face liquidation. In practice this means that ECB liquidity will be used pro-actively well before any bank faces going into liquidation.

After this surrender on bank regulation, ECB Governing Council member Francois Villeroy de Galhau then had the temerity to lecture the Brits and the Americans, for the current Anglo-Saxon watering down of regulations. He chose to frame this as an attack of protectionism. Presumably, what’s good for the goose is good for the gander, so the ECB is having a gander at weakening its governance rules in order for the Eurozone financial sector to remain globally competitive!

In the next recession, therefore, the submerged festering issue of NPL’s will immediately spring forth and the ECB will be forced to save the banks. In the meantime not only economic reform but also the pace of consolidation in the banking sector can now go into reverse. European nations still get to protect their banks and their tax payers rather than the central Eurozone budget will be on the hook again in the next credit crisis. The ECB will however make sure that said taxpayers are not on the hook so much that they become Populists and destroy the Eurozone. Plus ca change, plus cést la meme chose!

ECB Governing Council member and generally accepted thought leader Philip Lane signaled that the ECB is also looking further beyond the banks for potential macrostability risk and bailout contenders. Speaking at a thought leadership gathering, he acknowledged that in principle central banks should now be preparing to bail out non-bank lending institutions since these types of lender are increasing in significance.

Confirming that the ECB’s plans for regulating non-bank institutions are a little further along than just the thought leadership stage, Governing Council member Francois Villeroy de Galhau suggested that stress tests for such shadow lenders should become the norm. France in particular has strong reasons to be concerned about macrostability issues. Recently, the Bank of France and Treasury Joint Stability Council opined a warning about the boom in credit. The council advised that additional credit tightening rules should be adopted and that bank lending should be capped also. Evidently, the worry in France is that the relatively slow progress towards normalization of monetary policy by the ECB is creating macrostability risks.

As the Eurozone abruptly slows down, the ECB has swiftly pulled back from forcing banks into taking capital adequacy tightening steps which would act as a pro-cyclical headwind. At the same time, the ECB is attempting to mitigate the negative halo effect of the slowdown by projecting its own halo that this is just a temporary phenomenon. It is clear that the ECB neither has a conventional monetary policy interest rate cushion, like the Fed is building, to deal with any slowdown. Nor has it created a macrostability buffer in the banking system to endure any slowdown. Deeper fiscal reform and economic integration is on pause, which may become a permanent feature. A fiscal stimulus by national governments with weaker economies is possible, but they are already starting off from a deep deficit hole which may create more risk than commensurate economic stimulus. Germany is the only nation capable of unleashing a fiscal stimulus and it is unlikely to share this with its neighbors. The ECB will thus be forced to take up the heavy economic lifting again. As Vice President Constancio predicts, all that it has got is unconventional monetary policy however.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.