NN IP: On European politics and the ECB

Merkel/Macron and the Italian election outcome

Germany’s SPD party has managed to make a fairly big mark on the coalition agreement underlying the country’s new government. This opens the door for a constructive dialogue between Chancellor Angela Merkel and French President Emmanuel Macron, which will probably result in a larger degree of risk- and burden-sharing in Europe than would have been possible under the previous German government. Whether that will result in a set of EMU institutions strong enough to weather the next storm remains to be seen. 

These institutions have two parts: the enforcement of a common set of rules and some degree of solidarity. The rules need to become more symmetric. The current fiscal compact has a deflationary bias because it forces deficit countries into austerity, while there is no mechanism to force countries with ample fiscal room to stimulate their economies. As far as solidarity is concerned, some pundits have argued that the required solidarity in public sector space can be reduced by moving towards a true banking and capital markets union. In such a world the physical location of banks does not matter anymore (which prevents a lethal feedback loop between bank and sovereign balance sheets), while markets benefit from a level playing field in terms of regulation and tax regimes.

The idea here is that such a situation will reduce the risk of a destabilizing sudden stop in capital flows towards countries in trouble. We believe this argument has some merit. Still, history clearly shows that a system of fixed exchange rates is always susceptible to a sudden panic-driven stop in private capital flows. In fact, financial markets act more often as amplifiers rather than as disciplining/stabilizing devices. During a boom, markets tend to enhance capital flows toward current account deficit nations, which leads to an excessive compression of risk premia on its assets. During a panic, one tends to see an excessive and self-fulling widening of risk premia. Because of this, the Euro system will always need a public sector backstop to contain and stabilize the system.

No one really knows if an equilibrium set of institutions exists that will both make the monetary union resilient against shocks and be politically acceptable. The latter condition will not easily be fulfilled because countries differ considerably in their preferences in this respect. In reaction to the Macron-Merkel compromise in the making, the Netherlands is leading a coalition of eight small countries (some of which are not in the Euro area) that argues against any material further sharing of burden and risk. This coalition instead puts all its cards on a stricter application of the current rules of the fiscal compact and on making EMU sovereign debt even more risky by forcing a country into default if it gets into trouble. In times of panic this could actually force a sovereign into a self-fulfilling default if there is no liquidity backstop.

The Dutch-led coalition seems to believe that the sole cause of the crisis resides in peripheral profligacy, and that none of this would have happened if these countries had just kept their fiscal house in order or if they had prevented their domestic credit and housing booms. But the real cause of the EMU crisis resides in destabilizing capital flows. The core and the periphery are equally responsible. Hence, any institutional arrangement that seeks to limit these risks in the future should be a symmetrical one. Some kind of risk-sharing that substitutes for a sudden stop in private capital flows is an essential part of this. More generally, it is in every single member’s interest that all others perform well. They are all in the same monetary boat together.

Another potential complication for the Merkel/Macron compromise comes from Italy, where the Eurosceptic parties M5S and Northern League made surprisingly strong showings in the country’s elections earlier this month. In theory, these parties could form a coalition but at this point this is a tail risk. They are very far apart on many issues, apart from their attitude towards the EU. Because the centre-right block did not obtain a majority, M5S may well be asked to start negotiations. The centre-left PD would be the most likely partner, but they seem very reluctant for now.

One common feature of most parties is that they are all critical of the fiscal rules embodied in the Fiscal Compact and would like to see more flexibility there. The new Italian government is most likely to clash with the EU on this front rather than on the issue of EMU membership itself. In this respect, Italy could be a complicating factor in the process of making EMU institutions more resilient. In these matters, though, the whole package is what counts. For example, much depends on the trade-off between fiscal flexibility on the one hand and steps toward reform and efforts to deal with legacy problems on the other.

Unfortunately, the Italian political landscape does not make things easier with regard to reform and legacy problems. We have long held the view that the absence of large-scale fiscal easing and the possibility of devaluation means that structural reforms accompanied by sufficient demand growth are the only way Italy can achieve sustained higher economic growth. Hence, in the short term, the risks around Italy are probably limited due to the fact that Italy has a current account surplus, a low stock of net foreign debt, a strong home bias in sovereign bond space and a high average debt maturity. As long as the expansion continues and the ECB moves to the exit gradually, these factors should ensure that Italian spreads remain contained. Risks could arise in the more medium term if the cycle rolls over and Italy turns back the clock on structural reforms and refuses to comply with the fiscal rules. In that case Italy runs an increased risk of being cut off from risk-sharing mechanisms. 

ECB continues to tiptoe towards the exit

There is some pretty convincing circumstantial evidence for the hypothesis that inflation expectations have fallen below the ECB’s target. This will make it more difficult for the ECB to reach an inflation rate “below but close to 2%” in a sustainable way. Additional complications are the possibility of hidden labour market slack not counted in the unemployment rate and the potential for the NAIRU to move downwards in response to structural reform, increased productivity growth or persistently strong demand growth.

All these question marks have created a real debate within the ECB about whether there could be more slack than the ECB has assumed so far. According to Draghi the ECB is even entertaining the notion that the supply side may respond endogenously to the demand side. All this comes alongside a decrease in the NAIRU estimate in the ECB’s survey of professional forecasters. This suggests that both within the ECB and among the community of ECB watchers, the view on slack is moving in a more dovish direction.

The ECB continues to find itself faced with an expansion that is surprising on the upside but also with an inflation outlook that lacks any signs of a convincing and self-sustaining upturn. Of course, the observation about slack in the previous section is the lynchpin which connects these two issues. As a result, ECB policy has been “reactive” rather than pro-active, as Draghi put it. In other words, the ECB is displaying an underwhelming response to improvements in the data with the aim of preventing financial conditions from tightening too much. In a normal cycle the latter tends to happen because better data cause the market to price in a faster pace of tightening. Policy is thus explicitly designed to lean against this tendency and it has been very successful in this respect over the past few years.

Of course, financial conditions have tightened since the December meeting due to rising yields, a weaker equity market and a stronger euro. The ECB is not too worried about this because of the strong underlying growth momentum. Stronger underlying growth means that the economy is better able to absorb a tightening of financial conditions. Technically this happens because the “neutral level of financial conditions” (a mapping of r-star into the rest of financial asset space) will rise on the back of stronger growth. Still, this tightening is probably the reason why the growth forecasts for 2019 and 2020 were not raised, despite a stronger domestic and global momentum (which triggered an upward growth revision for 2018). Consistent with this, the inflation forecast for 2020 remains at 1.7%.

The ECB’s reactive response does not mean there will not be any changes to the policy mix. In fact the ECB is in the process of engineering a gradual rebalancing across instruments. As we argued before, an important driver here is the fact that net asset purchases are running into scarcity constraints. At the same time the ECB also tied their continuation explicitly to progress towards price stability. The tension between these two facts calls for a cautious approach and so far the ECB has pulled this off very well.

ECB Board Member Benoit Coeuré gave an important speech last month in which he elevated the importance of reinvestment of maturing assets on the ECB balance sheet to keep the stock constant. His central hypothesis is that the effectiveness of a given pace of net asset purchases in terms of suppressing the term premium will rise with the stock of assets already acquired. The reason for this is that there is a large captive audience for sovereign bonds that is relatively price insensitive (e.g., insurers and pension funds). As the stock of bonds available to the private sector decreases, the influence of this captive audience on price-setting will increase. For core country government bonds it holds that the share of outstanding bonds in the private sector has fallen to a very low level. Because of this, any decrease in the demand for these bonds (for instance due to an ongoing recovery and an increase in risk appetite) will only have a small effect on the price; i.e., the term premium will only rise by a small amount. In such an environment the ECB can stop its flow of net asset purchases and still ensure a low level of the term premium by keeping the scarcity situation intact via its reinvestment policy.

The speech fits perfectly in the game plan of de-emphasizing net asset purchases as the active policy instrument and putting more weight on reinvestment policy and rate guidance. In this respect, the ECB took another small step in March by dropping the QE easing bias, which pertains to the promise to increase size and/or duration of the program in the event of an unwarranted tightening of financial conditions or insufficient progress on the inflation front. This easing bias was instated when the ECB cut the pace of purchases from EUR 80 billion to EUR 60 billion in December 2016 and was meant as a signal that the central bank would revert back to EUR 80 billion if needed. As time progressed this signal became more superfluous; i.e., it was a “put” option that grew increasingly out of the money. Hence, dropping it was an easy concession to make to the hawks, especially because in exchange for it Draghi managed to preserve the main gains of the October meeting, i.e., keeping net asset purchases open-ended and preserving the “well past” part of rate guidance.

The open-ended nature of QE is essential to retaining the credibility that net asset purchases are tied to progress towards price stability. In particular, if inflation fails to pick up sufficiently, the ECB still has the option of maintaining a small, token amount of monthly purchases, the sole purpose of which would be to push expectations of the first rate hike further out into the future. Maintaining the promise that rates will be on hold until “well past” the end of QE fits perfectly in this strategy. In view of all this we feel there is no reason to change our ECB outlook for a gradual taper towards zero between September and December and a first rate hike in mid-2019.

Emerging markets: China may soften deleveraging efforts

Growth momentum in emerging economies improved again in the past few weeks after turning negative in February. Our proprietary EM growth momentum indicator is now at zero. This reading means that, on balance, growth in the 22 emerging markets we cover is neither improving nor deteriorating on a three-month basis.

The key trend of the past few quarters continues: domestic demand indicators strengthen while export-related indicators soften or no longer strengthen. At the basis of this stands the steady recovery of EM credit growth ex-China to currently 10%. More clarity about the strength of EM export growth should come in the coming months after the Chinese New Year data fog clears.

So far, we have seen some softening, but mainly in more forward-looking indicators. This might be partly explained by the trade-restriction noise created by the US government. Looking at individual countries, growth momentum is strengthening in India, Brazil, Russia and South Africa, and weakening in Indonesia, Philippines, South Korea, Mexico and Poland.

Remarkably, Chinese growth momentum has still not turned negative, despite the strong policy focus on financial-system risks and deleveraging. While the National People’s Congress of the past two weeks clearly confirmed this policy focus, and financial regulation is likely to be tightened even more, we are also seeing some tentative signs that the deleveraging campaign might be eased a bit. Broad credit growth in China has hardly moved in the past four months after declining at a pace of about half a percentage point in 2017.

As always, China’s policy makers are very much aware of potential risks to economic growth. It seems they are preparing themselves for more global headwinds, possibly from more trade protectionism.