The Limits of Monetary Policy

There was nothing very surprising in Mario Draghi’s ECB press conference. He promised to ease more. There was nothing very surprising in the market response. Previous announcements of easing have been accompanied by rising asset prices. This is not illogical as the tools being deployed involve printing money to purchase assets. This has both direct and indirect (positive) effects on asset prices.

Like Pavlov’s dogs that were conditioned to salivate on the sound of a bell (on expectation of food), so the markets salivate when they hear ‘more easing’. There is no doubt more easing will follow from the ECB.

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The object of ECB policy is not however asset price inflation. It is goods price inflation. Asset price inflation is a channel through which the ECB hopes to influence goods price inflation. Is this channel effective?

Low interest rates and Quantitative Easing have been features of the monetary policy seen globally since 2009. Asset prices have soared since 2009. Inflation is nowhere in evidence. In fact we have experienced deflation, a great deflation.

Now many bankers would dispute this assertion. Inflation has flatlined close to zero but has not been negative for long periods. Moreover, measures of so-called ‘core’ inflation have been higher. All true enough but rather missing the point.

The intensity of the global inflationary shock that was caused by the 2008 financial crisis was bigger than anyone seems to have grasped.
It would have been much worse had certain actions not been take. One grossly misunderstood action was bank recapitalisation by governments. This protected the unsecured depositors and senior bond holders:
Imagine a global experience like that of Cyprus in 2013. Cyprus currently has 70% loan delinquency with 59% categorised as serious.

  • -Bank shareholders globally lost money.
  • -Banks contracted staffing levels.
  • -Junior bond holders lost money.
  • Unsecured depositors remained untouched (except in Cyprus). Today Lloyds bank shares trade above the price at which the UK government purchased them. Who got bailed out at the expense of whom? Nevertheless, the reaction of the peanut gallery to the so-called bank bailout jaundiced attitudes to banks. There was a strong reaction to ‘too big to fail’ classification of banks. All this did was put unsecured depositors potentially at risk thus instantly degrading the practice that all bank deposits are money. Insured deposits perhaps still are but unsecured deposits are simply that, unsecured loans to banks that you can access. An overnight collapse in the money stock. This exacerbated the initial inflationary shock is a less visible way.

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    Many dispute the materiality of the collapse in the money stock. After all QE put money directly into the system. The CB buys assets and gives cash to the holder. Many of these assets are risk free government bonds.

    What does the holder do with the cash? Put it in a bank as an unsecured deposit?
    QE removed risk free near money assets from the system just when they were most needed. How did this help boost inflation? It did reduce yields on risk free assets to very low levels and this affected the cost of borrowing. It does not however seem to have encouraged borrowing for investment in productive activity. The main effect seems to have been to boost purchases of other assets such as equities and property. Companies bought back their own stock rather than build new plant. So QE is good for asset prices but after 6 years we still have deflation.

    QE = Quantitative Easing: Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.

    Monetary policy: is the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).The Federal Reserve is in charge of the United States’ monetary policy.

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    Gestaltz

    There was nothing very surprising in Mario Draghi’s ECB press conference. He promised to ease more. There was nothing very surprising in the market response. Previous announcements of easing have been accompanied by rising asset prices. This is not illogical as the tools being deployed involve printing money to purchase assets. This has both direct and indirect (positive) effects on asset prices. Like Pavlov’s dogs that were conditioned to salivate on the sound of a bell (on expectation of food), so the markets salivate when they hear ‘more easing’. There is no doubt more easing will follow from the ECB.

    The object of ECB policy is not however asset price inflation. It is goods price inflation. Asset price inflation is a channel through which the ECB hopes to influence goods price inflation. Is this channel effective? Low interest rates and Quantitative Easing have been features of the monetary policy seen…

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