ECB as Anchor of Stability
At today’s meeting the Governing Council of the European Central Bank (ECB) kept the interest rate on the main refinancing operations of the Eurosystem at 1.00%.
In the press conference following the announcement, ECB President Trichet focused on how the trust in the ECB’s handling of the credit crisis is the main driver of an anchoring of medium and long-term inflationary expectations. When asked about the exit strategy, Trichet emphasized that the ECB programs are "constructed for easy exit."
We fully agree with Trichet’s assessment and put them in stark contrast with the FOMC Minutes released yesterday:
- The ECB has focused on providing unlimited liquidity to the banking system by providing short-term loans; the longest such programs last a year (a new 12-month open market operation will be allotted 30 September at the main refinancing rate of 1%). These can be phased out by simply not renewing them. In contrast, the Fed has been buying structured securities, hundreds of billions of which will not mature for many years. The Fed has indicated it wants to rely on reverse purchase agreements, amongst others, to mop up excess liquidity – such "reverse repos" are unproven on such a large scale. By design, the Fed’s program raises many questions and increases uncertainty that they will be able to execute successfully.
- In the Q&A session of the ECB press conference, Trichet was asked about plans by the German government to use KfW, a special purpose bank engaged in development projects worldwide, to provide loans to German industry; the question was whether the ECB felt criticized that the government would need to step in as money made available to the banking system does not make its way to industry. The question itself shows a gross misunderstanding of what the role of a central bank should be – if the ECB were to provide credit to specific sectors of the economy, it would be engaging in fiscal rather than monetary policy. Providing credit to specific industries is a political decision to be made by elected officials – yet that’s precisely what the Fed is doing in the U.S. We applaud the ECB for staying on its own turf. In contrast, with its credit easing programs, the Fed has veered into fiscal territory, inviting political scrutiny that may, ultimately, jeopardize the Fed’s independence.
- This week has shown that an open press conference is far more effective in communicating monetary policy than issuing minutes. The ECB press conference displayed a unified monetary policy. In contrast, the Fed minutes showed major gaps in opinion and understanding of policies. There is the FOMC participant who suggested the Fed buy adjustable rate mortgage backed securities (ARM MBS) – as if that market deserved to be jump-started. Then there is the discussion of what we have in the past called the fairy tale of suggesting that the slack in the economy will keep inflation down. Indeed, the FOMC minutes state, "several [participants] were skeptical that temporarily low levels of resource utilization would reduce inflation appreciably, given the loose empirical relationship of economic slack to inflation and the fact that the public did not appear to have reduced its expectations to inflation. … To address these concerns, it would be important to continue communicating…" – thank goodness that the Fed is aware that inflation is primarily a result of inflationary expectations, i.e. the trust in the central bank’s ability to pursue sound monetary policy, rather than the output gap. However, the conclusion should not be to further promote ("continue communicating") the fairy tale of the output gap in order to buy time to further pursue its current policy of printing money, but rather the Fed should shift to a policy that focuses on price stability. It is no coincidence, we believe, that the ECB is working hard to distance itself from the Fed’s policies (without stating so explicitly).
Regarding the outlook of European monetary policy, the ECB changed its wording from removing its liquidity programs quickly once the macroeconmic environment improves to removing liquidity in a timely fashion. While others have suggested that the ECB may not raise rates for some time, we believe this wording emphasizes that it will let its programs simply run out rather than neutralize them with open market operations such as reverse repos. In today’s meeting, little attention was given to the fact that the ECB has emphasized in the past that it may raise interest rates before the liquidity programs run out. Indeed, we believe the ECB may start raising rates in early 2010 rather than late in 2010 as many others are forecasting.
In summary, the ECB is providing substance to its goal of being an anchor of stability in this turbulent time.
Axel
Axel Merk
Author of Sustainable Wealth, now available for pre-order.
President and Chief Investment Officer, Merk Investments
