Thoughts through the cycle: W1 November ’20

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The ECB’s Christine Lagarde and a new type of inflation

  • There are some issues in economics where there is, as it were, still an open verdict. An example of this, and one surprisingly critical to the current financial system, is a dispute over what banks actually do with respect to the economy. The debate has three standpoints: that the banking system is fractional in that individual banks can’t increase the amount of credit but the banking system as a whole can; that banks act as neutral intermediaries putting lenders together with borrowers but don’t increase the overall amount of credit in the system; and finally that individual banks can create loans without first having deposits to lend against, thereby meaning that banks really do increase the stock of credit through their day-to-day activity. The focus of debate is currently between the second (intermediary) and third (credit-creating) options.
  • One thing that isn’t normally a matter of debate is whether rising prices means inflation, and falling prices mean deflation. Or so you would think. Step into the limelight ECB President and soi-disant ‘owl’ of central banking Christine Lagarde and her world-class skills of dissimulation. During the ECB’s press conference on 29th October, Lagarde tried to claim that Europe was not suffering from deflation but something new called ‘negative inflation’. Perhaps surprisingly, Lagarde wasn’t attempting to lie – the graph below shows that CPI inflation data for the major European countries is indeed either at zero or below. She was in fact trying to build a case for further monetary and fiscal stimulus due to the rapidly deteriorating economic situation in Europe, and thus was emphasising how worrying the situation is becoming.

Source: Bloomberg, 30th October 2020.

  • Lagarde’s problem goes beyond just having to create neologisms. The desire to call it negative inflation is driven purely by a need to deny the existence of deflation, as deflation during a period of high government debt means a debt-deflation trap, a situation which is incredibly difficult to exit and one which is characterised by bankruptcy, high unemployment and social disruption (i.e.: the 1930s). Lagarde also wants to distance herself from the continued failure of ECB monetary policy. Target inflation is 2%. The graph below of Eurozone CPI shows how this target has continually been missed since 2012.

Source: Bloomberg, 30th October 2020.

  • What is a girl to do? Lagarde spent much of the Q&A session emphasising how all options were available to the ECB, which the market took to mean the possibility of further rate cuts (the ECB’s deposit facility rate is currently at -0.5% following a 10-basis point cut in September 2019). There is a growing consensus amongst market commentators (both pre- and post-ECB meeting) that an increase in quantitative easing (QE) will be announced at December’s policy meeting. The number being mooted is €500b, although it is unclear if this will be part of the pandemic emergency purchase programme (PEPP) with its greater flexibility in terms of what the ECB can buy and at what pace.
  • Lagarde again emphasised how government fiscal spending is absolutely critical to economic stability as European countries one-by-one return to lockdown or near-lockdown. This is in the context of the European recovery fund already floundering due to  the sort of petty national difference which seem to plague every euro-crisis, and which in fact are at the root of all the crises themselves due to the perverted belief that a single currency would lead to economic convergence amongst member states rather than convergence actually being a pre-requisite of a single currency (and indeed that a totally homogenous economic area with different currencies wouldn’t in fact need a single currency to bind it together…).
  • The ECB launched QE in March 2015, and as can be seen from the CPI inflation graph above, if its purpose was indeed to generate inflation, then in this respect, QE has self-evidently been a failure. Despite this, the market began salivating over the prospect of more QE Like a dog in a sausage-factory, the euro falling 0.61% on the day against the US dollar. If there is any chance of inflation, perhaps the successful debasement of the euro offers some prospect of that, but in the context of a burgeoning currency war, the euro is not the only contender in this particular fight.
  • The ECB’s rhetoric on inflation is starting to wear thin when it is held up to the data showing what is really going on, casting the central bank in a role of a would-be Aladdin perpetually rubbing their policy lamp in the vain hope of releasing the inflation genie. The reality is that the European recovery was really a dead-cat bounce, and data was already rolling over before the lockdown announcement in late October. The graph below shows an assortment of measures of German business and consumer confidence rolling over in September and early October or failing to return to their previous levels. For southern European countries like Spain and Italy, the situation is far more serious.

Source: Bloomberg, 30th October 2020.

  • Part of the modern central bank mantra is preventing the market from panicking, and this is in part the reason for the cult of activity which most central bankers seem to adhere to. In many respects though, central bankers are really slaves to the growing stock of debt in the world as they know that market collapse beckons if policy isn’t directed to ever greater levels of dovishness and easing. There was a brief taste of that in February and March when even the mighty Fed found its Sunday-night mega-announcements failing to assuage market worries.
  • There is a real consequence for the economy from more QE and further rate cuts below the lower-bound of zero. Rather than describing it, it is possible just to see the effect on the European banking system of an ECB policy stance which led to the advent of a recession with policy rates already negative. The graph below shows the SX7E European banking sector sub-index. On the eve of the global financial crisis in 2007, the index stood at over 450. In 2020 it is now fighting to stay above 50, with many of the components trading so far below book value that their share prices act only as some sort of long-dated option on the Eurozone pulling through its endless crisis.

Source: Bloomberg, 30th October 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Like good financial engineers, the ECB has done some terribly clever things to offset the catastrophic effect of negative policy rates on bank profitability. The ECB’s new targeted longer-term refinancing operation (TLTRO III) offers borrowing rates more negative than the negative policy rate to allow the banks to scalp a small profit even below the zero bound and thereby ward-off insolvency. The issue that such dual-rate policies don’t address is how negative rates and the over-indebtedness that causes it leads to falling demand for credit in the real economy, and what lending there is tends to favour the life-in-death of zombie companies where unproductive debt is simply rolled over in perpetuity. This is the ‘pushing on a string’ dilemma Keynes warned of in his General Theory of Employment. It’s the debt-deflation trap that Lagarde is trying to hide by calling it negative inflation not deflation.
  • She might have been more credible had she not begun her opening statement by referencing the recent ECB bank lending survey which, as one might expect in a recession, bears witness to tightening credit standards. Even those who want to borrow are finding it tough. This is pretty standard behaviour in a recession, and certainly not behaviour that would in the slightest bit be changed by more QE or another rate cut further below zero.
  • The graph below is the one which really matters, as it isn’t just a record of central-bank QE-driven yield manipulation but one of how the real economy is shaping up in Europe in 2020 based on ECB banking data. The yellow line shows household credit demand in 2020. The blue line shows bank credit standards for those households still wishing to borrow. The collapse in credit demand and the spike in standards suggests both the absence of a demand-driven recovery and also the present unwillingness of the banks to finance one even if it were to exist.

Source: Bloomberg, 30th October 2020.

  • A few weeks ago, Germany’s chancellor Angela Merkel said Germany couldn’t afford a second lockdown but it looks like there is one being implemented right now. If Germany is struggling, then the rest of Europe must be in more trouble. If households are struggling, then the small- and medium-sized business sector is likely in the same boat, and this in turn means the banks are going to have a real time of it in the next 12 months. If negative inflation is the new deflation, what’s the new eurozone crisis going to be called?

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