Un aperçu de ce qu’il va se passer

Key points:

  • The global dataflow is not changing much, between still struggling manufacturing and resilient services. But at least the balance of risk has improved since the central banks’ latest stimulus. They have time to pause and reflect.
  • The ECB’s strategy review will probably discuss the inflation target at length. We think we will end up with a more symmetric one. This is crucial to allow “overshooting” in the future which is in our view a solution to the ECB’s predicament, However, we are concerned with the temptation to add explicit “ranges” around the mid-point.
  • In any case, the main issue for the central bank is less the definition of its target than the depletion of its arsenal. Some “thinking outside the box” is taking place at the moment, but the solutions being discussed are quite thorny in terms of financial stability or political acceptability.

Cycle unchanged – central banks have time to reflect

International politics are still dominating markets and the cyclical trajectory. As the news-flow continues to improve on trade war, tensions between the US and Iran took centre-stage. De-escalation seems to be the likeliest scenario now, since the Iranian retaliation did not have any lethal consequences on US troops (probably a red line for the US administration), but the situation remains very fluid.

The dataflow has not changed with the new year. The global manufacturing sector remains in contraction while the economy at large is more resilient. This was neatly illustrated by the contrast in the US between the steep decline in December in the manufacturing ISM to the lowest level since June 2009 and the improvement in the non-manufacturing one. The immediate market reaction to the December Payrolls was negative, but the trend remains decent, with a three-month average at around 185k these last 5 months, higher than last spring.

What is maybe more concerning was the unexpected slowdown in US wages. Payrolls are notoriously volatile, so we don’t want to read too much into that, but this may strengthen our view that any re-acceleration in economic activity is being capped by the mediocrity of productivity gains. Without them, one cannot have at the same time high job creation, strong wage growth and robust investment. We focus in particular on the latter in a context of declining profit margins which Donald Trump’s corporate tax cuts and the Federal Reserve’s easing cannot hide any more.

Still, the balance of risk on the world economy has certainly improved since the Federal Reserve and the European Central banks provided their last batch of stimulus. They have time to pause and reflect.

At her first press conference as European Central Bank (ECB) President, Christine Lagarde hinted at a very wide scope to the strategic review, touching upon inequality and environmental issues. We want to focus in this “monetary policy special” on what we think are the two interconnected “pillars”: the definition of the central bank’s target and the operational framework, i.e. the arsenal on which the ECB could draw to deliver on its target.

Towards a “properly symmetric” target

Towards the end of his tenure, Draghi was increasingly referring to the notion that the ECB’s target – keeping inflation below but close to 2% in the medium run – was symmetric, i.e. that the ECB would be equally concerned by inflation being too low or too high. This is a very elastic understanding of “below but close”.

When in 2003 the central bank felt the need to keep “below” on top of the more straightforward “close to 2%” (shifting from the previous definition of “below 2%”),  it implicitly reflected the persistence of a “bigger concern” with inflation overshooting. This interpretation is explicitly shared by the authors of the ECB’s huge working paper on “ A tale of two decades: the ECB’s monetary policy at 20”, released in December 2019, which we suspect is intended as providing a discussion basis to the strategic review.  To quote them precisely, “the upper ceiling may have indeed promoted expectations that the ECB would penalise inflation above 2% more vigorously”. We think it would make more sense to dispose of the “below” if the ECB is now truly symmetric.

Are we splitting hairs here? After all, the central bank is already unable to bring inflation to its current target. There is something a bit presumptuous in “raising the bar” when bringing inflation to 1.7% or 1.8% would already be seen as a massive achievement. But moving to a proper symmetric target would lay the ground for tolerating future inflation overshooting, which we think is key to restoring the ECB’s credibility.

The ECB last week released another intriguing research paper rescuing the “Phillips curve” (the relationship between economic slack and inflation). It is a cottage industry – yours truly partook in his previous life on the sell-side – but we think there are some crucial monetary policy lessons to draw from it. Their main point is that core inflation is still driven by capacity utilisation (in this instance they use the output gap) when controlling for inflation expectations and lagged headline inflation shocks.

Let’s start with the latter. In plain English it means core inflation today is influenced by past episodes of very low or very high headline inflation. These shocks tend to be exogenous to the “normal” operation of the economy – typically food or commodity price hikes. But they end up percolating to “endogenous” price pressure, for instance because they influence wage negotiations. A policy conclusion we could draw from the paper is that we actually need such a shock to lift core inflation at last, and that the ECB should actually tolerate it – i.e. maintain an accommodative stance even though headline inflation would exceed 2% for possibly quite some time. This would be opposite of what the central bank did in 2011 when it overreacted to the rebound in commodity and headline inflation and started hiking again, before being forced into a policy reversal by the end of the year.

Let’s continue with inflation expectations. The – not original - point here is that if economic agents believe inflation could return or even exceed the central bank’s target in the future without triggering a policy tightening, then actual core inflation may at last start rising. A symmetric target with its hint at future over-shooting would help. We think a fairly wide consensus within the ECB – or at least within the ECB staff in charge of monetary policy strategy  who wrote the “tale of two decades” paper – has been reached on this. Indeed, in this paper the “asymmetry” was justified by the pre-Great Recession inflation regime, which was in their narrative characterised by frequent positive inflation exogenous shocks. In this specific configuration, instilling the belief that the central bank would “over-react” if these shocks became persistent actually helped anchoring actual core inflation at 2%. The paper conversely acknowledges that the post-Great Recession inflation regime, with its succession of negative inflation shocks, made the “ceiling approach” obsolete – or possibly counter-productive.

We are a bit sceptical about the “expectations” channel though, since in our reading the recent deterioration in expected inflation has not much to do with the fact economic agents have issues with what the central banks would do if headline inflation finally accelerated, but rather with how it could actually foster a persistent rise in inflation given the lack of a convincing policy arsenal (we will come back to this issue in the last section of this note.

Still, at the margin, at least telegraphing a potential openness to tolerating inflation overshooting would not hurt inflation expectations, or to turn the argument upside down, now that that there is a growing market attention to this issue of “symmetry”, choosing NOT to remove the “below” from the target’s definition on the occasion of this strategic review would be seen as a victory of the most hawkish members of the Governing Council – always ready to tolerate close to zero inflation for long periods of time – and this could actually lower expected inflation further.  

What about ranges?

In his “farewell speech” on December 18th Benoit Coeuré explicitly advocated such change to the definition of the target, but he added that the ECB “could communicate the range of inflation outcomes which can be considered acceptable in normal times”. We think it is a slippery slope.

Coeuré’s point is that there is a danger in creating the impression the central bank is “omnipotent” and can fine tune inflation within a decimal point. However at the same time he deplores that most citizens don’t know exactly what the inflation target is. The “omnipotence” issue is thus manageable in our view, at least in terms of democratic accountability.

But more fundamentally an issue with explicit ranges is that they can justify some measure of complacency at the central bank. Coeuré is obviously aware of this risk and also stated in his speech that “the ECB would need to establish a clean track record that emphasis the centrality of the mid-point”. We agree but we also understand this as meaning it would be a mistake to make ranges explicit before the central bank actually manages to bring inflation back to 2% and keep it there – and preferably a bit higher – for a long while. In other words, the ranges should be an item for the next strategic review, not this one.

We also suspect the debate on “ranges” was started by those who focus on the inflation target/financial stability trade-off. Indeed, we fully accept that at some point a too-accommodative monetary policy, striving to deliver on the inflation target at all cost, could actually generate the financial stability issues which could in the future trigger another massive economic slowdown which could wipe out all progress made on price stability. In these circumstances, ranges could come handy – the central bank could target for a while the lower end of the range and avoid getting into “dangerous” stimulus.

It would always be a delicate balance though. A “conservative” Governing Council could very well over-state financial stability risks and by doing so maintain the Euro area on a low-inflation and low-growth trajectory. This is why we find Coeure’s “in normal times” caveat interesting. We think we should read this as a way to avoid complacency when inflation is stuck at the lower end because the economy is not doing well. We think – should the ECB opt for explicit ranges – that more precise “safeguards” should be put in place.

There would be a case here to nod to the Fed’s dual mandate (full employment and price stability). In practice, the lower end of the target range for inflation could be tolerated by the ECB – i.e. would not require additional monetary accommodation - ONLY IF the economy is close to full employment. This would be an important qualifier, reducing the risk of a conservative bias, while still providing the central bank with some substantial room for manoeuvre, since there is no widely accepted precise quantification of full employment in the Euro area.

The temptation of tampering with the thermostat

It is probably natural that after spending years chasing the elusive 2% inflation the ECB is starting to wonder if inflation is accurately measured. We noted in Coeure’s speech this bit about whether the harmonised consumer prices index “adequately captures the cost of living …A well-known example is the cost of housing… Careful reflection is warranted but allowing a wedge to persist between the inflation that households perceive and the rate we officially measure can undermine the validity of our actions”. This point was echoed in a more recent speech by Banque de France Governor Villeroy de Galhau.

There is no obvious solution there however. True, the Euro area takes a very restrictive approach to incorporating housing-related costs into its measure of consumer prices since it only takes into account actual rents, while in the US the most common measure of inflation takes into account “imputed rents”, i.e. considers that rents are a good proxy for the “accommodation costs” owner-occupiers also face. In practice this is done easily by raising the weight of “rents” in the index. The impact would likely be small though. As an illustration in Exhibit 1 we raised the weight of rents by a factor of 2.5 to take into account the dominance of owner occupiers in most Euro area member states (Germany is a big exception in this pattern). The trajectory of core inflation would have barely changed over the last 5 years, with a maximum divergence of 20 basis points in the second half of 2015.

However, rents may not accurately reflect households’ perception of house prices, since they may be shaped by the cost of purchasing a house rather than renting it. In the long term, both measures of housing costs should converge, but in practice massive divergences may last for several years. However, economic consistency should not be sacrificed to “perceptions”. Most housing transactions take place between households: if the price of “second hand” houses rises, this depletes the purchasing power of the buyer but raises the wealth of the seller. Why should the price index reflect the former and not the latter? Eurostat has already come up with an experimental dataset of owner occupiers’ housing costs which focuses on “new dwellings” (thus excluding those purchased from other households). According to ECB research itself in 2016, incorporating this experimental data in the inflation index would not change much: “Indicative ECB calculations, made to illustrate the scale of the potential effect of including the national OOH indices into the euro area HICP, imply absolute differences in the inflation rates of up to 0.2 percentage points in any individual quarter, but no difference on average over the past five years”.

Exhibit 1 – Moving to “imputed rents” would not alter much the inflation trajectory

We would add that if the ECB wanted to get a better sense of housing-related “inflation perceptions”, then the measure should also take into account mortgage rates. This would introduce some interesting conceptual issues, since the ECB’s policy rates would end up having a counter-intuitive direct impact on the inflation it is targeting, since a component of the consumer price index would react negatively to a decline in policy rates  (bringing us back to a very old policy debate in the UK which was solved by excluding mortgage rates from the measure of retail prices).

The “what” is already hard enough, but what about the “how”?

All this will make for interesting if arcane discussions, but ultimately this massive expense of brainpower will be lost if the central bank cannot answer the crucial question: how can it help delivering on its inflation target, whatever definition is retained in the end.

At first glance, there is a scenario in which the ECB does not need to use up its arsenal more and inflation finally normalises merely by waiting. It is the apparent beauty of “overshooting”. It is more by NOT doing anything – refraining from tightening in spite of an acceleration in inflation – than by doing something that the central bank would restore its credibility. At some point, some exogenous shock will occur and the mechanics of overshooting on inflation expectations will kick in.

The “only” problem is that it is not obvious that a positive exogenous inflation shock could be persistent enough to lift core inflation and inflation expectations if the ECB cannot provide additional accommodation instead of merely staying put. Indeed, these shocks tend to have a negative effect on growth because they reduce consumers’ purchasing power. The transmission channel from headline to core described in the ECB’s paper on the Phillips curve can be impaired if slack rises too much.  This gets us back to what is in our view the thorniest issue the ECB needs to contemplate in this strategy review: the depletion of its arsenal.

In the “tale of two decades” paper ECB economists provide an interesting quantification of the relative impact on GDP  growth in 2017 of the three most recent instruments used by the central bank: 60% for quantitative easing (QE), 20% for  the negative deposit rate and finally 20% for the Targeted Longer Term Refinancing Operations (TLTROs). In other words, the most politically constrained instrument of the ECB is also the most efficient one. It is unlikely in our view the strategy review will provide strong hints at whether and how QE’s limits could be pushed if need be, because ultimately these are political and even legal issues on which the Governing Council has limited influence.

Some alternative instruments are being contemplated. We briefly discuss two of them here: Coeuré’s digital currency issued by the ECB, and Eric Lonergan’s deeply negative rate TLTROs. We find them both conceptually attractive, and potentially worrisome from a financial stability or a political point of view.

In his farewell Speech Coeuré mentioned the possibility for the ECB to issue digital currency directly to households, charging an interest rate on it. We suspect this would mean in practice issuing households with a “debit card” whose value would diminish over time (a negative interest rate) thus incentivising them to spend immediately instead of saving. This is conceptually brilliant, but beyond the technical complexity, this would turn the ECB into a competitor of banks. Indeed, beyond their lending activity, banks make a large share of their income by providing wholesale and retail payment services. This would add to the pressure on the banking sector monetary policy is already exerting.

Eric Lonergan has proposed in a column in the Financial Times to completely decouple deposit and lending rates. While the ECB’s deposit rate would stay unchanged – or could even be brought back to zero – the ECB would offer banks TLTROs at deeply negative rates. Lonergan also advocates broadening the scope of the TLTROs allowance beyond loans to the corporate sector. This would allow to further incentivise non-financial agents to leverage themselves and boost economic growth, while mechanically expanding the banks’ intermediation margins, thus removing one of the major drawbacks of the current monetary policy stance.

This is quite seductive but we think we need to contemplate some of the consequences such a proposal would have on the “political economy” of the Euro area. Indeed, such a system would inherently generate losses for the ECB (the return on its assets would be lower than the cost of its liabilities). In itself this is not an issue – central banks in principle should be able to operate in negative equity – but we are a bit concerned with how this would be read politically. Indeed, the central banks pay dividends to their shareholder, the national governments. Ultimately, by depleting the dividend this approach would be akin to subsidising banks with public sector money.  Monetary policy often has fiscal effects. Savers complain when interest rates fall but they forget they have to pay less tax to the governments as their funding costs fall. But perceptions would matter. We suspect implementing such a system would trigger additional regulatory pressure on banks – parliaments would want to be sure the new profit margins would be “put to good use” – potentially cancelling the benefits of the system.

All in all, what we expect from the strategy review is a move to a properly symmetric inflation target, and we sense that “ranges” will be very tempting to a lot of Governing Council members for pure and less pure reasons. We are not convinced the central bank will manage to make its job easier by tweaking the measurement of inflation. But fundamentally, the ECB’s main problem is with its operational framework, and on this we fail to see which politically and technically sustainable instrument could provide resolution.


Upcoming events
Mon: Empire State mfg survey, prel. mfg and services PMIs, NAHB housing market index; Tue: industrial production; Thu: Philadelphia Fed index, current account; Fri: final GDP, PCE price index
Euro Area:
Mon: Composite Eurozone PMI, Eurozone, French and German mfg and services PMIs; Wed: final Eurozone HICP, German Ifo business climate index; Thu: French manufacturing Insee index
Mon: Composite, mfg and services PMIs, BoE Financial Stability report; Tue: unemployment; Wed: CPI; Thu: retail sales, BoE MPC decision; Fri: GfK consumer confidence, final Q3 GDP, PSNB
Mon: industrial production, retail sales, unemployment
Mon: prel. mfg and services PMI; Tue: trade balance Thu: BoJ meeting and decision

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