ECB not to 'turn Japanese'

The European Central Bank (EBC) recently announced measures to counter low inflationary trends. Here we look at the implications for global markets.

Music trivia buffs will know The Vapors 1980 hit ‘Turning Japanese.’ It gave a lot of school boys an excuse to jump around Samurai-style in classrooms.

In modern economic parlance, ‘turning Japanese’ means unusually low inflation that risks a slide into deflation. No policy maker wants that on their résumé.

Alert to this, the European Central Bank (ECB) recently announced a raft of measures to fight off disconcertingly low inflationary trends. The mainsteps were cutting the ECB’s benchmark interest rate from 0.25 per cent to 0.15 per cent, cutting its deposit rate from zero to -0.10 per cent and lending to European banks at very low, fixed rates for a maximum of four years if they actually pump money into the economy by making business loans themselves.

Deflation and cash inertia

While the US, Britain and European economies have climbed away from their global crisis recessions, Europe is not growing quickly enough to be confident of heading off a steady decline in inflation. Annual inflation in the 18-nation Euro Area slid to 0.5 per cent at the end of May, down from 1.4 per cent a year earlier1.

In a deflationary economy, the prices of goods and services decline and the purchasing power of cash rises as time goes by. There is less incentive to take a risk and put money to work – less incentive for both individuals and companies including banks to borrow and invest to produce returns that in an inflationary environment preserve buying power and, hopefully, grow it.

The ECB’s moves are tied to the understanding that deflation gives cash inertia and a ‘carrots and sticks’ approach is being rolled out to change behaviour. At the centrepiece of the carrot component is a new loan program incentivising banks to lend more to small and medium sized enterprise (SMEs) by charging them just 25 basis points for four-year funding to kick-start corporate lending.

Implications for bank lending

There are no guarantees that banks will do the right thing by the ECB and increase their corporate funding. Instead, they may be tempted to funnel more funds towards sovereign bonds in a continuation of the carry trade, which while lowering risk from the banks’ perspective would do little for the economy.

The ECB is wise to this and will monitor banks’ lending programs and make them pay back the loans in two years if they have not used the funding as hoped. While the multiple steps don’t amount to outright quantitative easing – the purchase of financial assets – the ECB did say they are laying the groundwork to do so if the economy doesn’t respond. Markets are pleased by the boldness, but there are mixed views on whether it will have the desired impact.

The litmus test will be the level of lending to SMEs that follows. A lift in SME borrowing and higher prices across the economy may not eventuate for some time, however. Before then, a lower tracking for the Euro would be a sign that the ECB’s measures are having the desired effect.

Things may remain worryingly flat on the inflation front before they get better. It would be unsurprising if Q3 inflation remains at barely-there levels and inflationary expectations might even track lower in coming months. A weaker Euro needed to import relatively higher inflation and boost growth is not assured.

There could then be a test of wills between the ECB wanting to hold out until December before considering the quantitative easing option, and markets pressuring them to act sooner.

Medium term outlook

We’re not anticipating a black or white result, but rather one where there is a pick-up in SME financing as well as some increase in carry trade activity as investors take advantage of the gap between minuscule Euro interest rates and higher yielding markets.

Until the ECB’s recent actions, the Bank of Japan was the monetary policy outlier with its turbo-charged moves as part of Prime Minister Abe’s ‘Three Arrows’ economic revival program. Now, however, the global monetary policy picture has become more complicated with the emergence of two camps – the ‘inflation revivers’ Japan and Europe making up one group, and the ‘cautious interest rate normalisers’ New Zealand, the UK, Canada and the US forming the other faction (Figure 1).

Figure 1: Expect interest rate normalisers to take off the interest rate handbrake

Source: BBG. Interest rates from Q32014 in this chart are QIC forecasts.

New Zealand has already upped its official cash rate and we expect the UK, Canada and the US to begin fine-tuning back towards more normal rates at different stages later this year and into 2015.

Inflationary pressures are creeping forward in the US. April payroll growth was the highest in two years and May was solidly within expectations. The unemployment rate has fallen rapidly to 6.3 per cent and some measures of wage inflation are showing signs of turning up.

While markets are assuming that US interest rates, even if they go higher, will remain below the long-term average, we caution against complacency (Figure 2). If core inflation returns towards target faster than expected, investors should prepare for upside interest rate surprises.

Figure 2: Unwise to assume persistently below-average ‘normal’ interest rates



Source: Bloomberg

The enormity of managing the exit from quantitative easing and extraordinarily low interest rates in the US was conveyed earlier this year by Richard W. Fisher, President and CEO Federal Reserve Bank of Dallas when he remarked: “How do we pass a camel fattened by trillions of dollars of long-term, less-liquid purchases through the eye of the needle of getting back to a ‘normalized’ balance sheet so as to keep inflation under wraps and yet provide the right amount of monetary impetus for the economy to keep growing and expanding?”2

Long-suppressed volatility would finally re-emerge as monetary policy in the US as well as a number of other leading economies gradually normalises. Rather than fearing it, active investors should welcome it. Removal of the safety blanket provided by massive central bank intervention will compel investors to discriminate between assets and provide far more security and sector selection return opportunities, we believe.

1. European Central Bank Statistical Data Warehouse

2 . Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes.

Richard W. Fisher, President and CEO Federal Reserve Bank of Dallas, January 14, 2014.

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