Spain, the ECB and the power of talk

Over at Forbes, more on why the ECB won't do QE despite Spanish inflation having turned negative:
Spain is in a mess. Over a quarter of its adult workforce is unemployed, and according to CIB Natixis it has lost 25% of its production, even more than Greece. Spain’s inflation rate has been falling steadily and has now turned negative: the most recent retail sales figures show a fall of 0.2%. Various people anticipate ECB easing monetary policy because of the growing threat of deflation in Spain.
But this is to misunderstand the role of monetary policy in a currency union. The ECB sets monetary policy for the union as a single unit, not for its individual components. Deflation in Spain is a driver of ECB decisions only to the extent that it depresses Euro zone CPI. And I’m sorry if this sounds brutal, but Spanish unemployment is of no consequence, since the ECB does not have a mandate to target unemployment even at the Euro zone level, let alone in an individual country. The ECB can no more set policy to tackle deflation or unemployment in Spain than it can set policy to meet the desire of German savers for better returns. Its mandate is to maintain inflation close to 2% across the Euro zone economy AS A WHOLE.....
Read on here


  1. TravisV here from themoneyillusion comments section.

    Hi Frances!

    You make a lot of good points about the inflation forecast. I agree that it's a substantial obstacle.

    You also wrote this:

    "These market movements do not seem to be driven by fundamentals. Rather, they appear to be driven by expectations that the ECB will undertake more aggressive monetary easing, perhaps by means of QE or negative interest rates on bank reserves. The ECB has signaled that it is considering both of these.

    But I fear these expectations are wrong. Signals don’t necessarily equate to action, and if markets respond to the signal by pricing in the action, then they may render the action itself unnecessary."

    The market response to central bank surprises is a fascinating topic! I'm going to try to dig up Sumner's explanation for various strong market responses to Fed surprises, etc. One thing's for sure: we take substantial market reactions like Spanish and German stock prices last week very very seriously.

    One way to think of it: the market can tell that sentiment is shifting among the board members of the ECB. Now it estimates a higher probability for future easing than it did a week ago. Therefore, the market's estimate for the future path of aggregate demand (NGDP) is higher.

    1. Well, I'm really not sure what odds Paddy Power would give on the ECB doing QE right now, but I'm prepared to accept that the odds will shorten if inflation doesn't improve as the ECB forecasts.

      You asked about TIPS spreads: we don't have those as such in the Eurozone, but we do have inflation swaps, and they are more negative about inflation than the ECB's forecast. Here's the 5-year inflation swap:

      Not pretty. It really depends whether the ECB takes more notice of its own forecast than it does of the market's view. I think it will wait to see whether inflation expectations increase once the AQR is complete and (we hope) M3 lending improves.

  2. TravisV here from themoneyillusion comments section.

    I love the graph of inflation swaps, thanks! Expectations are fundamental!

    One key reason why Germany has persisted so long with tight money: most wealthy non-Eurozone countries are also too tight! Britain's monetary policy has been far better than average, I think. But Sweden's monetary policy is too tight. Poland's monetary policy is too tight. Almost uniformly throughout the rich world, monetary policy is too tight. Higher NGDP growth is needed in almost all wealthy countries. Australia is one singular unique exception.

    P.S.: I've noticed that Marcus Nunes and David Beckworth have written some excellent posts on Germany. Here is the key graph:

    And here are some other great posts:

    1. Thanks for the links, Travis. I've just posted a link on Scott's site - it's Lars Christensen on deflationary bias at the ECB. What he calls the Weidmann Rule essentially means that as soon as the Euro area shows any signs of life, ECB will tighten policy. I guess you could call this pro-German bias (since it comes from Weidmann), but it seems utterly counterproductive.

  3. TravisV here from themoneyillusion comments section.

    Frances Coppola,

    I have some links for the Sumner view of why U.S. stock prices surge upon the news of QE discussions. This would also be the explanation for the surge of Spanish and German stock prices last week.

    In this video:

    Listen to Sumner beginning at 1 hr 27 min and particularly at 1 hr 30 min about the "complicated game of trying to send signals to the markets"

    Also, here's a paragraph where Sumner describes how QE works:

    "So QE works for very simple reasons. Permanent monetary injections are effective even at the zero bound. QE programs are a signal that central banks would prefer at least slightly faster nominal GDP growth. Slightly faster nominal GDP growth requires that at least a small portion of the currency injection be permanent. So by signaling a preference for slightly faster nominal GDP growth, central banks are implicitly signaling a preference to have at least a small portion of the QE program be permanent (for any given IOR rate). Markets believe the central banks (and why shouldn’t they?) And hence asset prices react to the QE program."

    And here's more context: why Japan's 2001 QE didn't "work":

  4. TravisV here from themoneyillusion comments section.

    Wow! I just noticed that back in September 2012, George Soros advocated a 5% NGDP target for the Eurozone!

    Awesome! How many other 83-year olds have even heard of "Nominal GDP"?


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