Is Trichet out of his mind?!

Update: Ryan Avent links and comments on this post, as does Matthew Yglesias and David Beckworth. Paul Krugman has a slightly different and interesting take on the issue. Have a look!

Today European Central Bank (ECB) President Jean-Claude Trichet announced that rates are likely to increase in April (rather than later this year), sending the Euro upwards in terms of Dollar, Pound, …  So even though this was no “monetary policy action” in the wrong but common sense of that word, it was an effective tightening of policy in the Eurozone as the market reaction shows.

Five reasons for why this is a horrible idea.

1. Eurozone aggregate demand is 10% below trend, and falling!

If you consider Eurozone nominal GDP (aka aggregate demand), it keeps falling away from its moderate pre-crisis trend of about 4% p.a. Contrary to what adequate monetary policy would look like, namely a catch-up process with its trend so that the economy does not have to painfully adjust to a new trend, the ECB is not even targeting a new trend but somehow keeps looking for one. There are no words I could publicly use to describe this failure of monetary policy.

2. The Eurozone’s inflation target is unsuitable for a diverse currency union as it is!

The IMF suggested some time ago that a 4% inflation target might be better since it would give the central bank more room to act before it hits the zero lower bound. For a currency union, there is an additional reason: if regions of this union have asynchronous economic cycles, like Spain and Germany today, the nominal rigidity of wages and prices calls for a higher inflation target to ease the inevitable process of adjustment. In fact, the more uneven (or suboptimal) a currency union is, the higher the inflation target needs to be! If central bankers and economist didn’t know before this crisis, they should know by now.

One overlooked aspect of the IMF paper was that economists do not understand the relationship between inflation and output very well when the economy is hit by a severe shock. I completely agree, and the failure of inflation and interest rate focused macroeconomics is painfully obvious. So it would be even better to re-think the inflation target altogether since it offers the wrong guidance during a deep crisis like the one we are in now. If you still need to have one, choose a higher target, especially in a crisis like this. [no comments about the official, legal mandate of the ECB, please, we have seen how much these contracts are worth if things turn bad]

3. Headline inflation is not what matters!

If prices are driven by global demand, or adjust to new equilibrium prices, or both (as is likely the case for energy and food right now), this is not an issue for the central bank of a demand-weak country or region. Some people seem to remember the rule, but forgot the argument. Only inflation in wages is an issue for such a central bank to take care of. Are there any signs of a pass-through of headline inflation to core inflation? At 9.6% unemployment, with austerity programs kicking in, banking and public debt still on the edge of collapse and in fact tight monetary policy during the last 30 months (see 1.)? Highly unlikely.

Germany may see some increases in wages, at the same time as other countries will see even more wage moderation. Nobody knows how a restructuring of peripheral debt will play out. There are some signs for a pass-through, but they are very weak. In fact, energy and food prices won’t increase forever, they may just stay at a higher level. And then even headline inflation may fall again. I find it hard to imagine that the mid-term headline inflation outlook is anything but moderate.

4. If you do proper monetary policy, you can tighten faster!

Low interest rates are not a sign of easy money. They are a sign that money has been tight, as Friedman and recently Scott Sumner and Brad DeLong have argued.

Sweden was the first to raise rates and tighten policy after this crisis while having the strongest GDP growth ever recorded (see Matthew Yglesias). Why? It’s not that Swedish banks were not hit by the crisis, especially in Eastern Europe. It’s because its central bank has Lars Svesson on its board. He understands unconventional monetary policy better than most and his “targeting-the-forecast” approach to monetary policy was exactly right during the current crisis. Moreover, he was stubborn enough to push for easier money and negative interest on reserves, even when he was in the minority on the board.

Whether your country is depressed or not, globally driven energy and food prices can always lead to higher headline inflation. The best thing to do is to run adequate monetary policy to limit recessions because you can raise rates faster (Australia is another case in point). This in turn will calm the inflation hawks, or are the Swedish blaming the central bank for headline inflation?

5. The European debt crisis is far from over!

Debt levels remain high, and in some cases unsustainable. Nobody knows what this will mean for the European banking system. Some fear “the mother of all bank runs” if this turns ugly. I am not that pessimistic, but still worried. European legislation is unprepared for a severe banking crisis, even 2 years after the crisis in the US.

If there is a slight chance for solving this crisis without even more damage, the peripheral countries need to grow! How insanely incompetent do you have to be to worry about globally driven energy prices in a situation like this?

So is Trichet out of his mind? The only plausible explanation I have found so far is what Mark Schieritz over at Herdentrieb (the econblog of the German weekly “DIE ZEIT”) suggested: that Trichet wanted to send a signal to the price stability fetishists in Germany. In other words, the ECB will symbolically increase rates soon by 0.25 points, but keep it (longer?) at this rate. Trichet hinted at that when saying that this increase would not be the start of a series of rate hikes. However, the market reaction shows that this is not what happened. In the market’s interpretation, this announcement was a tightening of policy. Maybe that will change, if markets tomorrow think it was what Mark suggested.

How much worse can European monetary policy get? Not much. I thought. Trichet just proved me wrong.


  1. Henry Kaspar schreibt:

    Well I guess there are two issues here that one may wish to keep separate: (i) criticism of the European monetary policy framework for being insufficiently “Sumnerian” (something it shares with all monetary policy frameworks across the globe, btw) , and (ii) criticism of the ECB’s actions within the existing framework.

    The article focuses mostly on (i) — but as it happens Trichet, is responsible for (ii).

    Put differently: while one may find satisfaction in criticizing a plumber for not being a carpenter, it arguably makes more sense to criticize him for poor plumbing than for failing to build furniture.

    • kantoos schreibt:

      @ Henry, Jonas

      I couldn’t disagree more. Central banks, whose target is obviously insufficient to fight a severe crisis in a currency union, should show some flexibility (as others are doing, like the Bank of England) in interpreting their rules. Of course, they should not make up their own targets, and lose credibility along the way, but that is not the issue right now. If anything, the issue is about the central bank’s credibility in providing some form of macroeconomic stability within a crisis. It has completely lost that form of credibility, and this is even worse, considering future crises.

      If you think your target is insufficient (as you should, if you think a little about a currency union as suboptimal as the EMU plus a severe crisis), you should point out, like Mervyn King does, that in the medium term the risk of inflation above target are the same as the risk for below target inflation. There are always ways to argue for one or the other side, even within a strict framework like the European.

      In part you are right, and I should have extended my criticism to other folks at ECB, and in European governments. But Trichet is the key figure and he could fight for a monetary policy that actually makes sense. The current policy is a disaster.

      @ RL

      Yes, maybe. Still sad.

  2. Jonas Dovern schreibt:

    I can only support Henry’s view. I’d rather like to have technocrats in the ECB that – once they are appointed there is little “democratic power” to “control” their behavior – stick to the framework, which has been given to them by democratically elected (at least indirectly) bodies, than an ECB council that makes up its own targets and rules.

    In that sense Mr. Trichet is not the one to blame if one thinks that monetary policy is so unadequate that there are no words to describe it anymore.

  3. RL schreibt:

    Maybe by hawkishly pursuing a low inflation target as prescribed by the ECB’s statutes, Mr Trichet tries to demonstrate the inadequacy of these statutes ;-)

  4. matt_us schreibt:

    (1) The ECB is not working to the paradigm which kantoos envisages as optimal. There will be a long time before EU growth hits the trend line again. In the meantime, the ECB has to keep inflation at just below 2% over the medium term, to protect the poorest sector of the European population, and to protect its reputation, and keep inflation expectations at that level. Nothing wrong with that.

    (2) The ECB has not put rates up, and if the markets already price such a move in, that is a very smart Central Bank operation, because the ECB can hope to have the desired effect, without actually making money more expensive.

    (3) Another reason for this announcement on a possible rate rise, is in my opinion, to put pressure on EU governments to follow more closely the line which the ECB and to a lesser extent the EU Commission propose for the further governance of the Euro area. If, for example, a certain automatism was to be agreed, for countries which brake EU deficit rules, then the need for rate rises is much less, as these automatisms would have automatic deflationary effects.

  5. Rebecca Wilder schreibt:


    I suggested on Angry Bear that an inflation target, especially one set at just below 2%, is too simplistic for the Eurozone. You have implied as much here. My problem with the ECB’s position – one that’s separate from the points that you made regarding the economic ‘need’ to raise rates, i.e., nominal income remains well below trend – is that the central bank and fiscal policymakers seem to be playing a game of hot potato here.

    I interpreted the ECB’s position as being “unhappy” with the fact that Eurozone governments are showing no signs of resolving their differences on the liquidity mechanisms, EFSF and ESM (post 2013). Better put: they’re telling the governments, ‘you better get your act together, because we’re not doing it anymore’. In my view, the ECB has crossed the line between the two supposedly autonomous policies, moving into the fiscal realm by further suggesting that it’s up to the governments to tackle the liquidity crisis, not the ECB. (Note, they have left the SMP in place, but all signs point to the ECB wanting to drop, not raise, the size of their balance sheet).

    Bottom line: they SHOULD not hike in the face of fiscal austerity and growth challenging supply shocks, but they’re trying to force the governments’ hands by tightening. It’s a dangerous game; and I can envisage plenty of losers in this one.


    “In the meantime, the ECB has to keep inflation at just below 2% over the medium term, to protect the poorest sector of the European population,”

    The ECB in its own February 2011 Bulletin argues that ‘longer-term expectations have remained well-anchored at levels consistent with the ECB’s definition of price stability”.

    Thus, they see inflation anchored, core inflation’s showing no sign of perking up – where’s the inflation justification? There is none.

    It’s a dangerous political game they’re playing, and the region now is more susceptible to global shocks, especially the Peripheries.


    • kantoos schreibt:

      @ Rebecca

      Good thought, so it could be a signal that the ECB is no longer willing to contribute to solving a debt crisis. But is it really necessary to tighten policy to reach that goal? What about refusing to buy any more peripheral government bonds? That would work without tightening policy.

  6. matt_us schreibt:

    @ Rebecca Wilder

    I think your analysis is right when you say the ECB wants the EU governments, and especially the EFSF to take on the hot potatoe of looking after the periphery country debt.

    The ECB at the moment holds about 80 bn Euros in periphery country debt (Greece, Ireland, Portugal), and provides, in addition to that 330 bn Euros in liquidity support to Greek, Irish, Portuguese and Spanish banks. They still keep buying periphery country debt, if yields go over a certain rate.

    The ECB is right trying to move that hot potatoe to the EFSF, and make the EFSF as flexible as possible, as that will bring down yields. The EFSF could, e.g.,

    (1) make daily offers for small amounts of Greek debt at a yield of 4%, that would then me the market rate;
    (2) pass on the low rates which it has to pay for financing its own debt (perhaps much less than 3%) to buy periphery debt; and (3) start guaranteeing periphery country debt at a rate of maximum 1.5% p.a.

    That is why the ECB wants to extend the EFSF facility in both quantity and quality. An immediate ban on Credit Default Swaps would naturally help, too, as nobody would have an incentive to bet on a default of periphery country debt.

    The ECB will not be able to get the European inter-bankmarket working, unless the sovereign debt markets work for the periphery. That must be the job of the EFSF, to get that working, and drive bond yields down. Only then will the ECB be able to reduce its balance sheet, and get rid of its emergency asistance for periphery country banks. That is why the EFSF needs a mandate, which is as flexible as possible.

    Now can the ECB, by threatening to raise rates, or by implementing that rise of 0.25%, threaten the recovery of the Europeriphery? I doubt it. It would be somewhat of a preemptive strike, if core inflation has not risen by then, but would not be fatal, as market rates for bond debt increased by much more for these countries.

    More on the ECB position on the EU governance changes (very technical!):

    Here Mr Trichet making the same points in a speech to the University of Liege (more digestible):

  7. hkaspar schreibt:

    It’s one thing to demand flexibility (of which the ECB has shown quite a bit, btw, just look at the development of base money–harldy monetary policy as usual), and quite another to argue with NGDP falling below trend and the need to adopt a higher inflation target — both things Trichet could do nothing about even if he wanted.

    Now on substance I agree that the ECB’s policy is, at this juncture, too tight at the margin. Particularly convincing imo is the argument that more domestic demand, especially in the European “core” (first and foremost D, NL, A, to a lesser extent F, B) would make it easier to resolve the difficulties of the periphery. I just would frame the argument differenlty, actually much along Rebecca’s lines: inflation expectations are still well-anchored, core inflation is subdued, the large and in some countries growing output gap utside the core will continue to exert downward pressure on wages and prices–thus the ECB can use its hard-gained credibility to support adjustment in the euro area.

  8. matt_us schreibt:

    @ Rebecca Wilder

    I was trying to find your post 2013 onthe Angry Bear Log, but cannot find any reference numbers.

    I found this post instead, by accident, where you argue that Portuguese debt is less risky that Egyptian debt, even though both debts have the same CDS prices.

    THat just shows to me, what complete and utter nonsense these CDS prices are. The political risk in Egypt, must be higher than in Portugal, by far, no matter what the CDS rates say. Even if nominal growth is 10 times higher in Eqypt.

    (The fact that somebody tries to explain CDS contract problems whilst trying to wangle a lunch date is even funnier, though!)

  9. DS schreibt:

    Just a technical remark. I would say that this is not professional at all to compute and analyze GDP gap on nominal terms, do it rather on real levels.


  1. [...] Für alle die es härter mögen: Kantoos hat eine sehr kluge – und radikale – Kritik der EZB verfasst. Kategorien: Der aktuelle Rand, [...]

  2. [...] commented on the ECB’s latest blunder, but Paul Krugman, Matt Yglesias, David Beckworth, Kantoos, etc, have already said what needs to be [...]

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