ECB, PBOC and Global Wheezing

A lot of heavy breathing for very little oxygen intake. This should be the take away from this morning’s flurry of central bank activity from the ECB, the BOE and the PBOC.

The market is finally coming around to the realization that risk appetite is more important to sustainable monetary stimulus than central bank actions. Absent risk appetite—and it is absent—there is little risk of inflation and efforts to reflate will eventually fall back to earth.

The US, Europe, the UK and, I would argue, China are in liquidity traps, and the effects of monetary policy have proven to be largely psychological. The market now gets this. I believe this is what the underperformance of gold and silver is trying to tell us.

This doesn’t mean there is no role for monetary policy. There is. I will circle back to that below. But first I want to run over the implications for China and the ECB of this morning’s actions.


The PBOC cut its one year lending and deposit rates. The important thing to know about China is that even under normal circumstances lending in China is driven quantitative credit targets and not by price. But even from a micro prospective pricing is next to irrelevant. Think about it: when nominal GDP is growing at 15 percent, borrowing at four percent or seven percent starts looking like the same number. It really doesn’t matter. You just borrow.

If, however, your firm is under pressure, and you are concerned economic growth is falling precipitously—which I suspect is currently the base case in China—four and seven percent still look like the same number, but no longer in a good way.

Right now, however, the micro view matters less. The dominant point is that macro credit targets will no longer produce the results we all have become accustomed to. In the first place, they will be pushed less aggressively. As a consequence of the credit boom in 2009-10, the absorptive capacity of the Chinese economy is now diminished. Everyone who could borrow, has, and time is needed to digest the rapid credit growth (Brazil, mutatis mutandis, has a similar situation, IMO). Second, an important source of collateral behind the boom, local government ‘land banks’, have essentially been taken away by the decline in property values. And, finally, the central government—always incremental and afraid of the law of unintended consequences—is going to be extra careful this year given the political turbulence and upcoming transition. Put all this together and it becomes hard to imagine that the 8-8.5 trillion Yuan credit target analysts had penciled in for the PBOC in 2012 will be hit.

Bottom line: If you are banking on policy to save a constructive view on Chinese growth, there is still much scope for disappointment.

The ECB: Anderson Cooper is not alone

Mario Draghi finally came out and said what most of us already knew: the binding constraint on the flow of credit is on the demand side. In other words, Europe is in a liquidity trap. Yes, there are still more supply issues than Draghi implied given the need to recapitalize a fair amount of the EZ banking system, but even if the system were already properly capitalized the weakness on the demand side would keep growth in check.

There are two implications from this. One, the lending dynamic in the EZ is not sensitive to price. Second, the ECB’s forecast for a gentle recovery in the second half of 2012, which as Draghi today came out and said was predicated on low interest rates eventually kicking in, is, to put it charitably, highly suspect.

So why cut rates if lending is price inelastic? The first reason is signaling. The ECB has long had a reputation for erring on the side of tightening and being overly mechanistic in its approach (remember the hikes of July 2008, April 2011 and July 2011?). Cutting now shows that they recognize the issues and are not asleep at the wheel. Some might also be tempted to argue that the gesture was a hat tip to the EU for the recent summit agreements.

But I think the market will gravitate towards a simpler interpretation, now that participants better understand lower rates aren’t likely to stimulate credit growth or risk inflation. The market will conclude that the ECB is trying to engineer a weaker euro.

There is something to this. I’m sure the ECB wouldn’t mind seeing a weaker euro—at long at it comes in an orderly way. But we have to be careful not to over interpret. I think we in the market make two mistakes when we think about FX policy and the ECB. The first is overestimating the extent to which a reserve currency central bank can control its FX rate. We do this regularly. Yes, lowering rates matters, and signaling intentions does too, but ultimately it comes down to the stock adjustments and financial imbalances of major financial actors much more than it does the flows from economic fundamentals. This is much of why the Japanese yen defies the country’s poor fundamentals and why the euro has been stubbornly strong for so long relative to the EZ’s deteriorating economic backdrop. Those who have argued the Fed has been trying since 2008 to debase the dollar by printing trillions should also be naturally sympathetic to this view.

The second mistake we make is overestimating the extent to which a weaker euro will help growth. The EZ is a closed economic block. Exports are roughly 10 percent of EZ GDP. Most EZ trade is with other EZ countries (and this is also where the imbalances are). As a result, it would take a monster boost in exports to turn the GDP dial in any discernible way.

In addition, exports from the EZ tend to be more price inelastic than those of other economic blocks. Europe is a high-cost producer. People often buy from the EZ when they can’t get the quality they need anywhere else. They are sensitive to quality, not price. If they were highly sensitive to price, it is likely that they would already be buying from China or another developing country.

So, if your economy is closed and the price elasticity of demand for your exports is low, your currency would have to be much, much weaker to generate the change in quantities necessary to support GDP.  And, guess what? This is likely where we are headed with the euro.

Final quick comment on monetary policy in the context of a liquidity trap

I don’t mean to suggest that monetary policy is useless in this environment. There are a couple ways in which it can still have a meaningful impact. Indeed, there is a fairly robust debate going on about the extent to which central banks can influence inflationary expectations if they were to really go all in. I remain skeptical of the argument, and I think going all in along the lines advocated by the most aggressive proponents is highly unlikely in all but the most dramatic of circumstances, but I understand that I may be wrong and that in certain circumstances it might be worth running the attendant risks. But what is more germane is that central bank action can still elicit a psychological response, even if only a diminishing one. It still has enough juice, in my view, to short circuit the periodic self-reinforcing negative feedback loops that markets have been stumbling into since the Great Deleveraging began. And this, still, can be a valuable card to keep up your sleeve.