The Omnipresent Future Of ECB Unconventional Monetary Policy Is Here

by: Adam Whitehead

The ECB attempts to downplay the lingering recession risk from Q1/2018 that it lacks anything else other than unconventional monetary policy to deal with.

A big question mark over inflation or disinflation is evident from ECB's silence on the matter.

Rising global trade uncertainty is raising ECB concerns.

Outgoing ECB Vice President Constancio reinserts the “no choice” commitment to ease again promise into guidance.

The fight between fiscal austerity and fiscal stimulus is being brought forward by the slowdown in economic activity.

(Source: Seeking Alpha)

As the Q1/2018 economic slowdown in the Eurozone is confirmed by the arrival of backward looking data, the ECB is nervously watching to see if this was accompanied by rising or falling prices. If it is the latter, this will be something that the ECB can live with. If it is the former, then the central bank faces a dilemma and a credibility challenge. The ECB claims that it wants to see higher inflation, but this is only the case when accompanied by economic growth also. Across the Atlantic, the Fed is ahead of the curve in dealing with this Stagflation risk. The ECB may fall behind this stagflation curve, should it appear. Simply blaming the rise of inflation on the "transient" oil price may not suffice as an excuse this time around although no doubt it will be trotted out as the catch all explanation of choice.

The last report observed the heightened recession risk in Germany. This core weakness has now been officially echoed in the periphery of the Eurozone by Italy's statistic's agency Istat. The Italian statistics agency says that there are now signs that the Italian economy is cooling. Falling economic output is now causing productivity to stagnate in aggregate across the Eurozone, once again with Germany and Italy being the greatest transgressors in this case.

The focus will however swiftly return to Germany. Eight hundred thousand unionized German construction workers recently received a backdated inflation busting 6% pay award. The inflation pressures are clearly rising in Germany.

The rising inflation risk from Germany should not be discounted in the face of softening economic activity in the Eurozone. A clear dilemma is building. The Bundesbank will be worried about wages rising more than output, and will demand tighter monetary policy as a consequence. This tighter monetary policy may be too tight for the other Eurozone nations however. This divergence of required monetary policy will become difficult for the ECB to manage. The ECB claims that it wants to see inflation rise, but Germany is the last place that it wants to see this happen in!

If these inflation pressures are not matched by commensurate rises in productivity, the situation will be more challenging for the ECB. Pausing the monetary policy normalization process for weak growth is one thing, but pausing it in the face of declining productivity will take some explaining, especially when the Euro is trading down on the FX markets.

The ECB's tactical mission, since the last Governing Council meeting, has been to play catch up and then swiftly get ahead of the incoming weak growth data, which appears to be continuing from Q1/2018 into early Q2. How the mission changes, to deal with the evolving inflation dynamic, is pending the incoming data.

ECB Governing Council member Francois Villeroy de Galhau initiated the mission by first framing the weak Q1 data as something to be expected and not to be surprised about. Choosing the narrow frame of reference of the French economy, he then classified the French slowdown as a "rebalancing", rather than a reversal of trend. A change in guidance is a practical necessity in his opinion, since the ECB has already committed to end QE this year, so it should not be viewed as a tightening signal. That being said he noted that the ECB may also guide on eventual interest rate rises to begin in 2019, although it is under no obligation to do so, if the data continues to show continued growth and rising inflation.

In a similar fashion to Villeroy Executive Board member Sabine Lautenschlaeger opined that, despite the Q1 slowdown, the Eurozone economy is within the bounds of expectations. Consequently, she is relaxed about the economic softness for now. Her commentary was noticeably lacking in referring to any view on inflation.

Villeroy was also assisted by Bundesbank President Jens Weidmann, who opined that "some observers already see evidence of an approaching end to the upswing in the recent economic slowdown, however, I think such worries are exaggerated." No talk of inflation from him.

ECB Chief Economist Peter Praet chimed in with his view that there has been a "moderation" of growth in the Eurozone. No talk of inflation here either.

Praet does not think that this "moderation" reflects a softening in aggregate demand, although he is also quick to say that monetary easing is still required. The ECB will therefore remain data dependent and time consistent with the normalization schedule.

Governing Council member Vitas Vasiliauskas still expects to end QE this year, and then start raising interest rates in June 2019. He still expects "solid and broad-based growth". With no discussion of inflation from him, a discernible trend in its omission from guidance was developing. He will however "have to wait until June" for "what our (ECB's) new projections will tell us" to confirm his positive view officially. It should be noted that ECB official projections have been pessimistic on growth and inflation, since the beginning of the year, so it is hard to see where his optimism for the future is coming from.

Governing Council member Jan Smets provided a balanced view in support of his colleagues. Whilst saying that a signal about the end of QE may be delivered in July, he also stated that the markets have correctly pushed back expectations for it to actually commence. Smets would like data dependency to prevail amongst his colleagues and market observers. Once again, the lack of specific commentary about inflation was telling in his discourse, although he indirectly covered the base by advising data dependency.

Governing Council member Philip Lane is a bit more Dovish than his colleagues and leaves the door open to acceptance that the slowdown may be more than temporary by indicating that he is data dependent. His bigger picture view of the medium to long term provides an even stronger Dovish context, in which "I (Lane) don't think monetary policy rates are going to move dramatically in the years to come. The market doesn't think monetary policy rates are going to move dramatically." In fairness to Lane, his view incorporates a reference to inflation that he specifically omits.

Governing Council member Ewald Nowotny is not prepared to believe that the slowdown is a permanent fixture. He advised his colleagues to focus on the imminence of the normalization, and to guide and behave commensurately. Once again the inflation component of his analysis is specifically lacking.

Underpinning the ECB's pro-active move, on the softening growth data front, is the developing trade war environment. The EU ratcheted up the retaliatory rhetoric with threats to reciprocate on President Trump's tariffs if they are not removed. Sensing the growing risk, that even a pause before resumption of normal trade relations creates for uncertainty and economic activity, the ECB recently published its own supporting documentation, which opines that whilst the Eurozone would suffer America would suffer even more in a full blow trade war between the two blocs. This growing uncertainty surrounding trade is something that is now worrying the ECB enough to knock-on to a delayed monetary policy normalization timetable.

(Source: Seeking Alpha)

Outgoing ECB Vice President Vitor Constancio framed the economic softness in far more Dovish tones than the previous speakers. Breaking the guidance trend of his colleagues, he referred to the inflation situation. He also did some reverse prescience of his own, by tracing the softness back in time to 2017 when he then failed to flag it. Speaking with prescient hindsight, he explained that the current caution surrounding the end of QE is " justified by the subdued inflation dynamics since the second half of 2017 and the recent levels of headline inflation." He noted that significant economic slack remains in place, so that the softness, in both growth and inflation data from 2017, can continue for some time further.

(Source: Seeking Alpha)

Constancio also repeated his valedictorian remarks, noted in the last article, which basically theorize that monetary policy will never again return to the conventional normal. He saved his best remark for last however.

In an attempt to set some kind of unwritten but generally accepted precedent, which in practice undermines the ECB's prime directive not to monetize sovereign debt, he said that that the ECB has "no excuse" other than to intervene in sovereign bond markets in the event of a liquidity crisis. With this comment, the notion of the ECB put becomes tangible again. This comment is similar to the reinserting of the previously dropped language that the ECB will ease again if the Eurozone economy slows. The last report noted that Governing Council member Villeroy de Galhau had created the opportunity to reinsert the ECB put clause. Constancio has availed himself of this opportunity, in light of the supporting empirical data, especially on the disinflation front which is key. Suddenly, the specter of QE being extended comes back into view based on his analysis. Hindsight is indeed 20/20 vision.

It is a pity that these ECB speakers never prepared the markets, for this potential extension of QE situation, with prescient guidance at the end of Q4/2017. This lack of prescience discredits the latest remedial attempts by Constancio to sound prescient. Indeed, at the time of this verbal omission, the Northern ECB members seemed in a distinct hurry to get the normalization debate started and concluded. The sudden tactical move to downplay the slowdown coincides with a wider strategic objective to create a Eurozone fiscal framework to deal with it.

(Source: PIMCO)

Constancio's view is framing perceptions and building market consensus. Said growing consensus has been summed up by PIMCO, with the house view that: "President Draghi's successor will face a different set of challenges. One will be the extent to which the ECB can normalise policy rates before the U.S. and Eurozone economies eventually fall into recession. A second challenge will be calibrating the instruments through which the ECB implements monetary policy."

From his unique insider's position former Bank of England deputy governor Paul Tucker has had the chance to see the brave new Commonwealth of Central Banks that PIMCO's finger is pointing at. The bottom line is that politicians and central bankers may come and go, however unconventional monetary policy outlasts them all. Central bankers and politicians therefore serve the purpose of unconventional monetary policy through their responses to the fickle and emotive public opinion which frames perceptions of this reality. What the true purpose of unconventional monetary policy is however is now anybody's guess. A cynical guess assumes it is for the purpose of preserving and inflating the value of financial assets however, rather than any temporal purposes political and/or economic in the real global economy.

A further glimpse of what the future for unconventional monetary policy expansion may hold recently turned up in Portugal of all places. Portugal like Germany is struggling to come up with enough sovereign bonds to meet its Capital Key limited quota for the current phase of ECB bond buying. Consequently, the Bank of Portugal has been substituting its sovereign debt with the supra-national debt from the European Stability Fund and its predecessors such as the European Financial Stability Facility. In practice, the actions of the Bank of Portugal are those of the ECB in a fiscally integrated Eurozone.

ECB President Mario Draghi recently gave policy makers a further nudge towards the deeper fiscal integration that the Bank of Portugal precedent sets. His choice of words however exposed the current systemic weakness, of highly indebted nations facing a further economic slowdown and attendant financial market instability. Draghi freely admitted that he does not think that said nations have the fiscal capabilities to take another significant hit. In a thinly disguised plea for fiscal burden sharing, he called for "an extra layer of stabilization" in the form of a "fiscal instrument" at the Eurozone level.

The model and the logic behind Eurozone economic reform combined with deeper economic integration suddenly become clear. Economic reform limits the amount of sovereign debt available that the ECB can buy, so that it will need a new universe of pooled Eurozone debt to enable its future QE bond buying.

(Source: Seeking Alpha)

A previous report observed the initiative taken by Governing Council member Philip Lane to create "Safe Bonds" for the ECB to buy. The Portuguese bond substitution process shows that this initiative is actually a live process currently flying under the radar screen. Mr. Lane's Herculean efforts to get the ECB's safety net in place, in time for the next crisis, were made all the more prescient by his recent observation that there is a "material risk" that Irish house prices may fall within the next two years. The IMF also recently underlined the prescience of Mr. Lane's view with its own warning about Irish house prices. ECB charity clearly begins at home in Mr. Lane's case!

Lane will have to move things along a little faster. The chaos in price discovery of the real versus historically understood risk in Eurozone bank subordinated debt is regularly creating flash crashes in this asset class, with alarming frequency, which appears when the price discoverers suddenly realize that their subordination may take the form of a total bail-in. There is about $74 billion of the pre-credit crisis bank junior debt, which is in the grey area of covenant interpretation that puts this bail-in risk very much into the elevated probability category.

This debt figure represents the tip of a much larger iceberg that is getting closer as the timetable for deeper economic integration is forcing banks to get their non-performing loan (NPL) books in order. Many of these toxic assets have been funded by the issuance of subordinated debt. Legacy pre-crisis debt is thus a challenge.

(Source: Daily Shot)

At the same time, evidence out of Spain suggests that the nation is just starting to give up on austerity. The nation has recently become one of net debtors again, for the first time since the crisis. Spanish banks are thus embarking on a new phase of credit expansion, without having dealt with the end of the last credit expansion on their balance sheets. Whilst this is welcome in signalling economic growth, it must be understood that this growth is not built on solid credit foundations.

It is logical and fitting that a fresh pair of eyes in the ECB policy making team should make the direct connection between the state of the NPL issue, deeper Eurozone economic integration and monetary policy, and then draw this line of connected dots on the Governing Council's radar screen. Olli Rehn has recently switched hats from policy making at the Commission to become the head of Finland's central bank. He is therefore well experienced in the dark arts of politics and economics which lie at the heart of the NPL issue. He now takes this arcane knowledge to the central bank of Finland and the ECB Governing Council.

Rehn recently opined that whilst he is satisfied with the ECB's short-term "broadly balanced" view, he sees that "currently, risks to the medium-term economic outlook seem to be tilted on the downside". His caution is driven by his view that "internal risks relate to uncertainties surrounding the implementation of reforms in the euro area, and to the public finances and banking sectors in some member states."

Rehn's solution to the NPL issue is right out of the German economic text book, however it places increased fiscal risk upon the already indebted nations. He suggests that the NPL issue should be handled "with a combination of bail-in and recapitalization by national funds" while banks with "high amounts of a single country's sovereign bonds" could be asked to have more capital. Rehn's prescience signals that the old Eurozone fight between fiscal austerity and fiscal stimulus is going to appear in the very near future, potentially brought forward by the prospect of an economic slowdown.

Mr. Rehn's view should be compared and contrasted with what the new populist government of Italy has recently proposed to solve the related bank and sovereign debt crisis. The Italian populists would have liked the ECB to write off 250 billion Euros of Italian debt.

To blackmail the ECB, the Italians had also proposed the introduction of legislation that will allow nations to formally leave the Eurozone, although they say that this is not their desired outcome. This threat was dead on arrival at the Eurozone level, with Commission Vice President Valdis Dombrovskis telling the Italians to stick to fiscal austerity, so the populists dropped it. The fact that they even proposed it however highlighted just how parlous the debt situation is in Italy. Perversely with no debt write off, the situation in Italy is even more acute.

This Italian problem scales across the Eurozone, which is why the Italian write off threat was dead on arrival. The precedent it would have set would have exploded throughout the Eurozone, with global ramifications, just as the Greek debt crisis did.

A large question mark therefore looms over the European NPL issue, the sovereign debt issue, deeper economic union and even Eurozone survival. The "downside" is starting to look very ominous and very imminent once again. No wonder Vitor Constancio would like to leave the lights of QE on in the Eurozone when he leaves the room!

Mr. Rehn's view of the looming global storm clouds and political discord were embellished further by the IMF. The Fund exactly concurs with both Rehn's view on the "balanced" short-term risk and "downside" medium term risk; in fact, it uses exactly the same words to describe them. The Fund then stands back and takes a bigger picture global view of the Eurozone in relation to the current global themes relating to trade.

The IMF is applying steady pressure on Germany to reverse its "Black Zero" policy, of creating twin trade and budget surpluses, in the face of a global slowdown and trade war risks. The Fund recently called for fiscal expansion and capital investment by Germany. This call was primarily made to address the issue of trade imbalances. When President Trump has done his deal with China, it can be expected that he will turn his full attention and Tweet invective on Germany specifically rather than the Eurozone as a whole. The IMF's latest comment is thus a warning shot in a much larger looming war.

Prompted into action by developments in the Eurozone and the comments from the IMF, Angela Merkel made some soothing globalist political noises for the press, which were completely without any actionable economic message. Noting the upcoming June meetings to make further progress on deeper Eurozone integration, Merkel suggested that now would be a good time to make further progress on this issue.

Merkel also noted that the ECB cannot be relied upon to provide easy monetary policy forever, so that a Eurozone wide fiscal safety net will need to be in place for the day when the central bank stops easing. The devil is always in the detail however, so that Merkel's broad brush strokes are lacking in any conditionality for access to this safety net or for whom will fund it. Given that both German coalition partners approve of "Black Zero" domestic fiscal policy, it is unlikely that they will contribute German taxpayer funds to a Eurozone safety net without all nations accepting fiscal austerity and real compliance with Stability Pact guidelines. Italy is clearly not up for these conditions, so it is hard to see any progress being made towards deeper economic integration in June. Consequently, the likelihood of the ECB retreating from QE will fall even further.

The last report discussed the consequences of the observation of ECB Vice President Vitor Constancio's lamenting of the fact that there is a distinct absence of macroprudential rules and buffers in place to deal with the impact of the next economic slowdown. In the said absence of rules and buffers, all the ECB has to deal with the situation is unconventional monetary policy, since thus far (unlike the Fed) it has not begun to build a conventional monetary policy cushion of higher interest rates. The Bank of France has decided to be pro-active and lead from the front in this matter. As a consequence of this directive, the French central bank has set Eurozone wide limits on the amount of exposure that French banks can take towards indebted French companies.

(Source: ECB)

Evidently, the ECB is also on a wider strategic mission to deal with the lack of macroprudential rules and buffers to counter-cyclically build in times of growth in order to prepare in advance for times of weakness. The central bank recently published its latest initiative in order to accelerate the process. This initiative begins with the call for a review of the current macroprudential framework.

Presumably, this review will expose the lack of buffers or rules and regulations that transfer directly from the Eurozone regulatory superstructure into the national regulatory governance and infrastructure of the individual Eurozone nations. This project will therefore get intercepted, impeded, distracted and diluted by the narrow national interests of Eurozone nations, who wish to protect their banking systems and prevent economic reforms that will come at a financial cost to said banks and taxpayers.

It is fair to speculate that, in the absence of deeper economic integration, the Eurozone may never get the regulations and buffers to deal with the next crisis. If the current economic slowdown becomes protracted and no progress is made on deeper economic integration in June, this assertion may get the chance to be tested.

Many commentators have noted how rising US interest rates and a rising US Dollar have destabilised the emerging markets. They forget that a fiscally integrated Eurozone is an emerging developed market all of its own. Absent the stabilizing influence of Germany, running the twin deficits that America does in order to keep the global economy afloat, only the ECB's unconventional monetary policy is and can be the heavy lifting force that holds it all together. Vitor Constancio and Mario Draghi both know this and have warned accordingly. Unfortunately for the Eurozone Project, they are both leaving.

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.