Credit conditions in Europe have obviously deteriorated sharply with the crisis during the summer. While the ultimate question is the extent to which such deterioration is affecting demand in the area, another issue is also pressing in the short run, regarding the speed with which financial markets will be returning to normal standards. Keeping the interest rate at the current level, while providing liquidity support, appears to be the best course of action. At given official rates, the increase in the level of market interest rate and the appreciation of the euro area have further tightened the overall monetary stance in Europe. Many indicators show that expectations of inflation are well anchored. What to do next will be clearer as information becomes available in the next few weeks. The next move, which appears open at this point, should not undermine price stability; yet it is important to keep in mind that the argument in favor or pre-emptive monetary policy works symmetrically for both contractions and expansions. The evolution of prices, especially of core inflation, and inflation expectations may provide valuable signals to detect early on the need to intervene on the monetary stance.
There are clearly two views.According to the first one, there is still no clear evidence that the liquidity crisis will have a significant macro impact on the Euro area. Hence, the ECB should keep providing liquidity without cuting rates. This first view also considers that cutting rates would produce wrong incentives in the future (moral hazard argument).
The alternative view is that when we see clear signs of GDP slowdown, it will be too late. So the ECB should act preemptively by cutting rates. At this stage, such cut would just compensate for the rise in market rates. Advocates of this alternative view consider that moral hazard appears before the crisis (when excessive risk is taken) rather than during the crisis (where the central bank needs to rescue the banking whatever the signal given to the markets in so doing).
I think both views are correct. However recent news do not seem to have changed inflation expectations in the Euro area so far. With a 2% growth rate (in 2008) and a 2% inflation rate, the present refinancing rate is still fine, and cutting rates today may well provide wrong signals to the markets. However the situation may change quickly especially if the euro continues on its way up. In brief, I think the ECB should keep rates on hold this time. Some communication concerning the ECB staff view on the impact of the euro on the consumer price index would be useful to guide market rates.
I think that the ECB should continue to provide liquidity to the market, to make its interest rate stick. I am against penalty, for the same reason as Thomas Mayer. I agree that credit is being squeezed and that this make monetary policy tighter. On the other hand, I don't think that a lower interest rate will change anything, the credit squeeze is not due to a too high interest rate. I am worried about the exchange rate but I think that, unfortunately, the dollar will keep depreciating quite further no matter what the ECB does. This is part of the global imbalance problem, which is currently being solved. The outlook for the euro area has darkened, which calls for lowering the interest rate, but the prognosis is very, very uncertain. I am willing to wait another month or two to make that decision.
It seems to me that too much credit and money supplied at too low an interest rate can be held responsible for the problems in the credit market. No doubt, the damage has been done, and a way has to be found how to end the crisis. However, I find it hard to see how lower interest rates – implying even more credit and money – could solve the trouble; it may simply sow the seeds for the next crisis.In fact, embarking on an inflationary monetary policy is presumably the worst option available. Should the crisis hit the banking system really hard – that is eroding its capacity to extend credit like in Japan in the early 1990s – it might be better to take recourse to taxpayers’ money rather than applying the inflation tax. Are there signs that inflation expectations are going up? I wonder what the rising gold price is telling us. Maybe it is just caused by the US-dollar trading lower, maybe it shows that people are about to lose confidence in central banks’ handling of the paper money system. I have the feeling that if central banks do not make pretty clear that they put preserving the value of the currency first, the credit crisis could spill over into a full-blown monetary crisis.
The economy entered the third quarter at a slower pace, and the burst of the credit bubble has increased considerably the downside risks to growth. The sharp tightening of financial conditions, both from interest rates and from the exchange rate, plus the likely reduction in credit availability and tightening of credit standards, are very likely to dampen growth in the foreseeable future. More than a month after the credit bubble burst the situation in European money markets has not improved, and at some point the central bank has to face the question: the cost of capital has increased sharply, do we need to offset this increase or not? The liquidity injections are probably helping markets - one can only wonder where libor rates would be had the ECB not injected massive amounts of money - but they no longer address the fundamental question of the risks to price stability. In this environment, my view is that the central bank has to be preemptive, not reactive, and thus offset the increase in the cost of capital before the weakness appears in the data. Inflation expectations are very well anchor and thus the central bank can afford to stabilize the business cycle. The shock is clear, and there is no reason to doubt of the negative consequences. Waiting for the weakness to appear in the data will only force the central bank to have to cut rates more later. Therefore, I am starting to lean towards voting for a rate cut. Unless conditions improve significantly in the next month, I will very likely vote for a rate cut at the next meeting.
Before the moral hazard argument is raised, let me say that my view is that moral hazard has to be dealt with during the good times, not during the bad times. If an individual institution is in trouble, then moral hazard applies and Bagehot's doctrine of lending at penalty rates applies. When the whole banking sector is under strain, as the persistence of the elevated Libor rate clearly suggests, then moral hazard does not apply. if most of the banking sector engaged in too risky activities during the upside, it was the fault of the regulators and supervisors who failed to curb that behavior - and not of interest rates being too low, by the way. Witness Spain, a country which has enjoyed negative real rates for an extended period of time and yet its financial sector has not engaged in any of the risky activates - ABCP, conduits and the like - that are at the heart of the current crunch. Why? because the authorities put in place very effective controls that limited risk taking during the upside. At the same time, Germany, where real rates have been on the high side, is where many of these risky activities have surfaced. Theory tells us that risk taking is unrelated to the level of interest rates, and this case study makes it very clear. This reinforces my long standing view that monetary policy should deal with price stability, and macro prudential supervision and regulation should deal with excessive risk taking. Asking monetary policy to achieve two objectives (price stability and financial stability) with one instrument is a recipe for likely failure on both counts.
Declines in the September surveys (PMI, Belgian BNB index, Ifo so far) suggest that the credit crunch of the financial sector is beginning to affect the business sector. Tighter credit conditions are soon likely to weigh on Euroland's overheated real estate markets and private consumption. In addition, the rising exchange rate is making life for exporters more difficult. In this environment, the ECB should leave rates unchanged and be prepared to cut if the fall-out from the credit crunch turns out even worse than presently visible.
They should also continue to provide overnight and term liquidity liberally at their regular rates. I find the excitement about the potential creation of moral hazard as a result of central bank support to the banking system peculiar. If I arrive at the scene of an accident, I don't refuse to call the ambulance because I sense that the driver was drunk and now want to teach him a lesson. Drunk driving, or excessive risk taking for that matter, needs to be prevented before it leads to acidents. Hence, central banks should not hesitate to ease financial sector problems, but they should reverse their emergency assistance quickly as soon as it is clear that it has fulfilled its purpose. More generally, central banks should in my view much more closely observe money, credit, and asset markets and be aware that they influence risk taking in these markets through their setting of the risk free rate (yes, I do believe the risk premium is endogenous and not exogenous as assumed in CAPM). The ECB's monetary pillar is useful in that it opens the central bank's eyes to these developments. But the ECB should de-emphasise the role of M3 in this pillar to avoid distraction and finally put the criticism to rest that they follow 1970-style monetary targeting. In reality, the ECB's broad approach is in my view much superior to narrow inflation targeting.
Since the last meeting, evidence has emerged that this summer’s tightening of financial conditions is undermining business confidence and, probably, activity. As a result, my suspicion that the 1H growth moderation to trend was genuine has been reinforced, and chances that growth will sink below trend in coming quarters are increasing. The ongoing appreciation of the euro – which I expect to continue – will further dent confidence and activity going forward. The near-term inflation outlook remains unchanged, with headline readings probably exceeding, just temporarily, 2% in the coming months, but with underlying measures and wages well under control. Against this background, there is no reason to raise rates again and, if these indications persist, an easing bias will be justified soon.
Regarding the situation of the money market, I believe that the ECB’s actions have been basically correct so far (aside from several communication failures.). The injections of extra liquidity since 9th August had the purpose of helping the banking system to fulfil, without undue strains, its reserve requirements, and the excess liquidity was fully drained in the last day (11th September.) Thus, there has not been any NET injection of liquidity. The same likely will happen in the current statement period. Under normal circumstances, banks with a shortage of liquidity should be penalized by ECB or the market by lending to them at rates higher than 4%. Those unnecessarily hoarding cash should be punished by allowing the O/N rate to fall below 4%, as happenned on 10-11th September. However, this strategy is questionable when the market as a whole has ceased to function. As long as there are no persistent NET injections of liquidity, there are no monetary policy implications from these actions at all. At the same time, the ECB should not allow the distortions in the money market to persist for long, and should encourage short-liquidity banks to find long-term funding (or sell other assets) to solve their situation on a permanent basis.
The increase in inter-bank rates plus the strengthening of the euro has already led to an effective tightening of monetary conditions by close to 50 bps. Moreover, the increased uncertainty in the economic outlook means that the option value of waiting has risen.
Due to the crisis in the short-term funding markets, monetary conditions in the euro area have tightened noticeably. Three-month Euribor interbank rates trade at around 4.75%, some 50 basis points above their pre-crisis level. In normal times, this would be consistent with an official refi rate of 4.5%, rather than the current 4.0%. Monetary policy has thus turned restrictive, with three-month Euribor rates standing some 75 basis points above our estimate of the neutral, or natural, rate of 4%. Moreover, the euro has strenghtened further. Higher short rates, tighter bank lending standards, a stronger euro and a slowing US consumer are likely to push euro area GDP growth below its trend pace in the coming quarters and reduce the upside risks to inflation over the short and medium term. I think the ECB should lean against the wind of the euro appreciation and reduce rates by 25 basis points. This would still leave the monetary policy stance slightly restrictive.
Due to the turbulent events since the end of June 2007, the US economic expansion in 2008 is likely to be around ½ percentage point lower than previously expected (2.2 % instead of 2.7 %). While the EMU economy is unlikely to escape the US real estate crises and turbulence on the financial markets totally unscathed, the impact will probably be limited: We have shaved one tenth of a percentage point off our GDP growth forecast for the euro area for 2008, bringing it down to 2.1 %.
In my opinion, the risk that the crisis of confidence on the financial markets will spark a general credit crunch for EMU companies is low. Nevertheless, banks are likely to subject their lending decisions to closer scrutiny and it is still difficult to estimate the extent to which the cost of lending will increase. However, at least as things stand, I do not expect any long-term effect on companies’ investing power in macroeconomic terms.
In the present situation the ECB should continue to take all technical measures necessary to provide enough liquidity to the money market. However, given the probably limited consequences for the real economy described above, it does not seem advisable to follow the Fed’s example and take quick monetary policy measures. On the other hand, continuing to signal a tightening bias does not seem advisable either, given the recent euro appreciation, which threatens to continue.
Until last week, it was still debatable whether the tightening in credit conditions was having an impact on the real economy or not. Indeed, available indicators suggested that the impact was largely limited to confidence rather than on activity. However, this has now changed with available indicators for September showing clear evidence that the financial turmoil has spread to the real economy: the decline in the services PMI index for September for example was the largest in the history of survey which started in 1998. The debate is now shifting on how protracted the impact will be. The rise in the cost of borrowing (around 40 basis points on circa Eur400bn lent to the corporate sector per month on a short term basis) and the decline in the availability of credit (through tightening credit standards) is likely to have a long lasting impact on the economy, most visibly on the availability of mortgage loans but also and more importantly on the availability of credit to corporates (this might take longer to become apparent as corporates might first use available lines of credits negotiated prior to these events before borrowing at higher costs).
Exchange rate developments also suggest that euro area growth could turn out weaker than expected in 2008: the impact of past appreciation has been less “visible” than in the past mostly because of a global backdrop that has helped offsetting the loss of competitiveness of the region as the income elasticity of euro area exports is well larger than their price elasticity. However, with signs of softening of foreign demand as proxied by OECD manufacturing output growth, euro area exports growth is likely to decline significantly. High commodity prices, while representing a short term cost push for euro area corporates, are likely to have a negative impact on demand rather than on inflation of final goods and services: in a context of high profit margins, the pass-through of elevated pipeline inflationary pressures is likely to remain muted and be absorbed via lower profit margins. Overall, these developments suggest that a wait and see stance is appropriate for now. However, a significant and long lasting deterioration in the economic outlook should open the door to a potential easing of the policy rate.
We don’t have a banking crisis yet. Two small German banks went belly-up and one small UK bank got itself into trouble, but we have not yet seen any material damage to any money centre bank that matters.However, the effective increase in the cost of funds and the reduced availability of credit will cause the real economy to slow down. As long as we don’t know by how much, the ECB should do what it has been doing: keep rates constant and provide liquidity to the markets.
My one concern is that the ECB may be providing liquidity too cheaply. They have not made the mistake of the Fed to cut the discount rate, but I would charge more than the 100 basis points premium of the Marginal Lending Facility over the policy rate if the borrower is offering highly illiquid collateral. I would also value the collateral extremely conservatively (use a big discount on face value) and apply a serious haircut to that conservative valuation. I am also concerned that the ECB may have assisted individual banks on too favourable terms, although there is no uncontrovertible evidence that they have assisted any individual bank. We must get a full accounting ex post, when orderly market conditions are restored, of who was helped and on exactly what terms. They are playing with tax payers’ money.
As regards exchange rates: We should expect the effective exchange rate of the US dollar to continue to depreciate, and the effective exchange rate of the euro to appreciate. Bilateral exchange rate movements are not very interesting.