By Michael Burke, B&M Research
The overall policy framework for the European Central Bank (ECB) remains largely unclear to most in the financial markets, and the policy-making process seems to be deliberately opaque. There is also a widespread perception that an aim of the European central bankers is to wrong-foot the financial markets regarding their interest rate decisions, which stands in marked contrast to the Fed.
The main operational and ideological influence on the ECB is the Bundesbank, and not solely because it was Europe’s pre-eminent central bank prior to European Monetary Union (EMU). In the run-up to EMU the other European central banks were obliged to emulate the Bundesbank, and did so in an increasingly enthusiastic way, in the manner of a late convert. As a result, the central banks of Europe are dominated by an outlook framed by the anti-inflation stance of the Bundesbank. Underpinning this is the ECB’s constitution, which is itself based largely on that of the Bundesbank. Therefore ECB policy should to some extent be regarded primarily as an extension and magnification of Bundesbank policy.
One of the legs of this policy is money supply targeting. However, the attachment to money supply targeting as a guide to interest rate policy (rather than as an input to inflation forecasts) is more rhetorical than actual. In the accompanying chart we show the German discount rate and the pace of German M3 money supply growth. There is no evidence here at all that M3 growth determines interest rate policy.
In both cases, Bundesbank and ECB, rates were cut when money supply was rising and/or above target, and have been hiked when money supply growth is slowing and/or below target. This could be justified, as the Bundesbank has previously pointed out, by reference to the fact that adjustments in short-term interest rates themselves have an effect on money supply growth. In this way, the Bundesbank justified cutting rates in 1993 as M3 soared by arguing that it would encourage bund buying (which they insisted on calling “gross fixed capital formation”), and so reduce money supply growth. Even so, however correctly the Bundesbank judged the effects of its interest rate policy (and M3 growth did decline subsequently), it is clear that the rate of M3 growth was no guide to Bundesbank interest rate policy, and seems to be no guide to ECB rate-setting either.
In reaction to the inter-War period of hyper-inflation, and its economic and political costs, the remit of the Bundesbank was to protect both the internal and external value of the Deutsche mark. The internal value was protected by a rigorous anti-inflation stance and the external value was protected by promoting a strong currency. To some extent, these two became self-reinforcing, especially against what were then inflation-prone European competitors and a highly-indebted US economy.
The nexus of these two factors, inflation and the currency, is to be found in import prices. It also seems to be the case that import price inflation is a key determinant of ECB interest rate policy. This is not to argue that the ECB is solely concerned with developments in the German economy, but that the variance between German and Euroland import price inflation will tend to be small, given the same conditions for world commodities prices and the introduction of the single European currency. (The timeliness of the German data is an additional bonus).
However, import prices are themselves determined primarily by two factors: the level of the currency and the level of world commodities prices (typically denominated in US dollars). The influence of the exchange rate on import price inflation would go some way to explaining the ECB’s reluctance to cut interest rates over a prolonged period. From the perspective of the European central bankers, there is no room to cut rates while a decline in the currency is fuelling a rise in import prices. So, the ECB only stopped hiking rates as the euro appreciated from EUR/USD 82 to EUR/USD 95 during the period September 2000 to February 2001. This is also an important factor in the very near-term, where the continued downtrend in the CRB index (falling by around 1.4% in January) is more than off-set by the decline in the euro (down over 3% in January).
However, the validity of this policy-making approach is questionable in relation to the very different external postions of the German economy and the Euroland economy. The Euroland economy is much more closed, with imports accounting for only around half the proportion of German GDP (12% versus 23%). Therefore, it is possible to argue that the ECB, in aping the Bundesbank, is ignoring the important specific differences of the two economies, and cannot therefore hope to emulate its success.
There is also a further key determinant of trends in short-term interest rates, namely the level of long-term interest rates. In nearly every instance, the level of long rates is a lead indicator for short-term rates. This should not be surprising. For the German economy, the key interest rate is long-term, with around 85% of commercial borrowing priced off government 10-year yields (the average maturity of Euroland commercial debt is slightly shorter, at around seven years). There is no point in cutting short-term interest rates if long-term interest rates rise, as this leads to an effective tightening of monetary conditions. In the Bundesbank’s oft-repeated defence of its slowly, slowly policy, “we only control one point on the yield curve”.
Based on these ideas, we have created a policy index for the ECB that incorporates these and other factors. The recent rebound in this index is a function of the combined back-up in European bond yields and fall in the euro. In our judgement, this does not necessarily mean the next move on rates is up; the index is comprised of variables that can adjust rapidly. However, it does make an early rate cut extremely unlikely.