Sunday, March 6, 2016

Macro: ECB - Rock and A Hard Place

ECB is widely expected to launch another round of monetary easing in the policy meeting this Thursday.

The chart below amply captures the apparent reason for an increased market expectation and willingness on the part of the central bank for further monetary stimulus. Both the general inflation (HICP here) and wage inflation (unit labor cost) levels are on a steady, relentless downward path.

However, notwithstanding the limitations of negative rates regime and QE, the moot question is how effective another round of monetary policy easing will be.

The contraction in Euro area credit growth since the financial crisis is still to see any sustained correction. And very lately it seems has turned another corner to unwind all the recovery made during last couple of years.

to dig deeper, we take a quick look at the ECB bank lending survey, that specifically probes the problems around demand and supply.

The survey shows a significant recovery in credit demand - both in terms of back-ward looking data and forward looking expectation. Similarly, the credit condition is comparable to the good days before the financial crisis

Going by these surveys, it appears neither credit tightening or potential demand is a problem right now. The relaxing of credit condition gradually started improving after the euro area sovereign crisis was averted, and now has settled down around the levels of best years during the pre-crisis era. The demand side started recovering a bit late, but nonetheless does not seems very off from the pre-crisis levels.

And this is no way a limited result. Even, the SAFE (Survey on the Access to Finance of Enterprises, latest April to September 2015) survey reports clearly notes:
"Euro area SMEs considered access to finance to be the least important problem that they faced (11% of respondents, unchanged from the previous round), although results differ across countries. Instead, finding customers remains their main concern (25% of respondents, down from 26% in the previous round)."
So what is the problem. Let's again look at the second chart again vis-à-vis US credit growth (technically it is not exactly apple to apple, as the US series is Bank Credit of All Commercial Banks from the FRED database, not just to resident non-government sectors). See the co-movement before the crisis and the decoupling after.

It seems a bit puzzling to say the least. The credit supply is definitely not under threat from credit standard tightening (i.e. no significant financial or liquidity stress). Nor the demand shows a particular hole in that area, at least according the surveys. Nonetheless the credit growth is dismal.

There can be many reasons. A recent note on the excellent IMF Blog hints at one - this probably can be a bank balance sheet and capital rules issue than a financial stress or liquidity story. And given the surveys, it seems the latent demand seems to be still around (note the contradiction of the SAFE survey and bank lending survey on the outlook on demand).

To me, it seems a further increase in liquidity or a reduction in rates will be just another round of insignificant attempt to correct the situation. The only effective monetary policy is perhaps an inflation expectation shock - and QE  (at least in its current avatar) is no shock anymore.

And on this front, what can really achieve a lot more bang for its buck is fiscal stimulus. Given the extraordinary economic situation, it is indeed surprising to see the tightness in fiscal situation is rivaling the pre-crisis period. But then again, unlike Canada, with average government debt of 90%+ of GDP, it is hard to push fiscal stimulus politically, even with the best of intention and economic clarity.

The most likely path for Euro area is to follow incremental monetary stimulus and hope for a global return of inflation, quick enough to avoid a general deflationary mind-set taking its root and a permanent damage to the potential output. Only a crisis can change things.

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