Wednesday, November 12, 2008

Trichet got it wrong

Jeane Claude Trichet, President of the European Central Bank (ECB), got it wrong. In his endless pursuit to cling to an inflation target, lack of early easing has doomed the Eurozone to a prolonged recession. Those countries that acted more preemptively (i.e., Ben Bernanke at the Fed) have facilitated a less-severe economic downturn.

Denyse Godoy and Clovis Rossi at FOLHA interviewed Jean Claude Trichet on November 8, 2008, and here is the headline question:
FOLHA – "It is a (paradigm) dogma that central banks should only pay attention to inflation and not to other points of the economy like jobs or consumer spending. You have indicated that you are, now, more concerned about growth than about inflation. In times of a severe crisis like these in which we are, isn’t that dogma correct anymore?”
Rebecca here. First, this question is inherently incorrect; an inflation target is not a policy rule, where the latter takes any discretionary policy response out of the equation. For example a Taylor rule tells the policy maker exactly what an inflation target should be under the current economic conditions as given by relative measures of current inflation and output. Although an inflation target is certainly less discretionary than a dual mandate, promoting maximum sustainable growth with low and predictable inflation (the Fed's dual mandate), but it is never-the-less an objective, rather than an explicit rule. Trichet could have eased.

Certainly, Trichet could have made a case for easing in order to relieve some of the downward risk to growth. But still, he clings to his mandate:
JEAN-CLAUDE TRICHET – “I didn’t say that. We are not changing the way we look at our monetary policy strategy. We consider that our primary mandate has been – it is today and will be tomorrow – to deliver price stability in the medium term. This is the mandate that we were asked to fulfill by the Treaty of Maastricht. In this perspective, we decided to decrease interest rates by 100 basis points in less than one month because we have observed a significant alleviation of inflationary pressures. We also took into account that we had regained control of medium term inflation expectations. That being said, I profoundly trust that by delivering price stability, we are contributing to sustainable growth, job creation and fostering financial stability. By being credible in delivering price stability over time, and by solidly anchoring inflation expectations, we are fostering, in very difficult times, the confidence of households. Our fellow citizens have to be reassured on the fact that their purchasing power will be preserved in the period to come. It is also very important for sustainable growth that all economic agents take appropriate decisions because they can rely on the credible delivery of price stability. A solid anchoring of inflation expectations also allows to have medium and long term market interest rates more favourable to growth and less volatile, which is essential in an episode of financial turbulences.

As regards these turbulences, we have been one of the first central banks in the world to react immediately, on August 9th, 2007, when we had the first tensions on the money markets. We decided to provide liquidity in order to put the market in a situation where it would function as normal as possible under the circumstances. But it is important to note that we apply a separation principle between our monetary policy stance, which is designed to deliver price stability in the medium term, and the implementation of this policy – at the level of interest rates decided to deliver price stability – which is managed with a view of appeasing the tensions in the money market.”
Rebecca here: I am sorry for all of the households and firms in the Eurozone because the economy is set to suffer comparatively longer than the U.S.; the central bank took too long to ease.

Trichet acted too late and didn’t protect the economy from a possible crash in the credit system, which came to pass. Nor did the ECB protect the economy from a possible recession, which also came to pass. The Fed has lowered its target rate 3.5% to 1% since November 2007 , while the ECB lowered just 0.75% to 3.25% over the year, including an 0.25% rate hike early in 2008. The 100 bps rate cut that he refers to did occur in the last month, but this will take a while to filter into the macroeconomy. And by the time it does, a severe recession will likely be underway.

It make sense that the ECB is easing right now. In some sense, it should be “printing money” just as the Fed is doing; the ECB's claim to fame as "acting first" on August 9th just isn't the same as easing substantially and printing money. With credit markets in shambles, central banks have a rare window of opportunity to print money in an attempt to buy the economy out of a severe credit crunch without any short-term inflation cost. The outcome: a deep and prolonged recession is avoided.

European labor markets are different than the U.S. labor market (see this post). Many European economies index wages heavily to inflation rates – Germany, Spain – and so the ECB is wary of the infamous "wage-price spiral". But still, the short-term economic stresses will far outweigh any medium term inflation pressures (wages or final goods prices) that may arise from the ECB markedly easing.

It is good for the European economies that Trichet finally figured this out, but I believe that he should have been easing months ago. It is almost like thi central banker was waiting for inflation to actually subside, which as any reasonable economist knows, by then it is too late.

Inflation pressures will re-emerge, and at this point, some could argue that this would be a good thing. Over the short term, price pressures have been mitigated almost completely, and central banks are free to ease to their liking. However, the real risk is that central banks get it wrong; they extract the liquidity too late and inflation booms.

I believe, though, that the Fed has proved itself to be forward-looking and it will take back the liquidity, once the economy is capable of surviving without life support. Not so sure about the ECB.

Rebecca Wilder


  1. Good Grief! It is November already!
    Your next to last sentence gave me pause. Do you think Bernanke and Co. are capable of withdrawing liquidity when it should? I can't remember anything that has been said on the subject.

  2. I'd like to hear how you support the assertion how the fed will justify taking back the liquidity. With tighter lending standards and a new financial memory going forward, I can't picture money velocity getting back to where it was. I thought velocity was a function of freeness of credit and investment. Why would credit ever be as free as it was in subprime days?

    Can money supply increases we've seen find their way to inflate prices of goods even with a lower baseline velocity?

  3. Taylor Rule = FED's nominal interest rate changes (pegs) when actual GDP divergences from potential GDP & actual inflation diverges from target inflation rate"

    (1) this approach is entirely ex post (severly lagging) & (2) the money supply can never be managed by any attempt to control the cost of credit (a Keynesian fallacy).

    Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP, i.e., money is the measure of liquidity and the transactions velocity of money is it's rate of turnover.

  4. Thank you all for your insightful comments!

    Hi Janie,

    Always good to hear from you! Also can’t believe its November.

    You said, “Do you think Bernanke and Co. are capable of withdrawing liquidity when it should?”

    Except for reducing the federal funds target to 1%, the Fed has been rather innovative in its liquidity measures. Much of the additional liquidity has been done by way of loans, which at some point (generally, 30-90 days) expire. So all the Fed would have to do is wait for the loans to expire, raise the discount rate (to curtail discount lending), schedule only minimal TAF auctions, stop the PDCF program, allow the CPFF loans to expire, and call in the currency swaps. The only sticky point is the TSLF – which has a $200 billion balance. The Fed could not unload those (swap them back for its Treasuries) until a market has been well defined for these assets). That market will come…eventually.

    Hi Ines,

    Thank you for your comment – I totally agree with you.

    You said, “I'd like to hear how you support the assertion how the fed will justify taking back the liquidity.”

    The Fed will not take back any liquidity until the credit crisis is “about” to pass and health has been restored to the banking system. The velocity of money may is certainly a function of tightness in lending, but as long as the base grows enough to overcompensate for that, the money supply will rise – and it is rising. Eventually this banking crisis will end, the recession will end, and there will be liquidity left in the system with bankers there to loan it out. I have always argued that banking will go back to its roots with a focus on consumer, small business, and mortgage lending; thus the velocity will recover.

    There is no reason for me to believe that the velocity will not remain fairly constant when all is said and done. Certainly financial restructuring (moving away from asset backed securities as the catalyst for easy credit) will occur, but that will be ongoing far after this recession is over and consumers are buying homes again.

    Hi Flow5,

    Good to hear from you again!

    You said, “(1) this approach is entirely ex post (severly lagging) & (2) the money supply can never be managed by any attempt to control the cost of credit (a Keynesian fallacy).”

    I totally agree, and do not support the Taylor Rule for anything except for getting a point across.


  5. I guess after the event, it seems that you got it completely wrong.

  6. Hello Anonymous,

    Are you able to be a little more specific? The German economy is set to decline this year by twice as much as the US economy, and the risk of sovereign default is rising across the eurozone (Spain, Greece). The economies in the Eurozone are surely no better off than in the US.

    A lot changed AFTER this article was written, and the ECB relaxed its policy stance quickly. For example, in March of 2009 the ECB relaxed the collateral accepted for its credit operations. Also, they enacted the covered bond purchase program. For all intents and purposes, the ECB was "credit easing".