Friday, March 14, 2014

Forward Guidance, Backward Progress: Taking Aim at Draghi

A few days ago, I tweeted: "When forward guidance with a reputation for credibility tackles an economy with a reputation for low NGDP growth, it's the reputation of the economy that remains intact." This was a poor and much less funny paraphrasing of Buffett's quip that "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." 

Mario Draghi's latest speech gives me another chance to point out what are some of the weaknesses of forward guidance. First of all, let me give Draghi credit for acknowledging "too low inflation" is currently more relevant than inflation being too high. Second, the acknowledgement of the dearth of capital for SMEs is positive because thankfully, he isn't saying "but rates are low in the Eurozone!". I also think the review of the banking sector is both necessary and welcome (if fraught with political issues).

Nevertheless, I simply couldn't resist disagreeing when he came to the section on monetary policy. Draghi said:
- The Governing Council is committed to keeping interest rates at present or lower levels for an extended period of times, which will help the deleveraging process through balance sheet channels.
- Forward guidance creates a de facto loosening of policy stance, leading to falling real interest rates. Falling real interest rates will support the demand for credit by encouraging higher business investment.
- A declining real interest rate spread between the Euro area and the rest of the world will, all else equal, put downward pressure on the exchange rate. Given the current levels of inflation, the level of the exchange rate is "becoming increasingly relevant in our assessment of price stability."
- Risks of deflation appear quite limited, but the longer inflation remains low, the higher the probability of such risks emerging. That's why the ECB has been preparing additional non-standard monetary policy measures to guard against such an event and why it stands ready to take further decisive action when needed. Any material risk of inflation expectations becoming unanchored will be countered with additional policy measures.

Some of this sounds reasonable enough. But let me make a few points:

1) Forward guidance is a weak tool:
- No serious person should think that investors' views are dominated by real interest rates (I mean those pursuing investment in the economic, not financial, sense). Talk to any businessperson and ask if they are thinking of expanding their operations. I can guarantee that their decision will be based on two things - growth and profitability. Businesses in the Eurozone aren't investing because their expectations of future economic growth are low. Committing to low future rates is much less powerful than committing to higher rates of future NGDP growth. I used to think that this "textbook" view of the interest rate channel was just the the way monetary policy was taught to simplify it for beginners. But it appears that policy makers genuinely believe that view, and I just think it's wrong. 
- Interest rates are currently low for safe assets in the Eurozone. This is not translating to healthy credit to SMEs. Unless the banking sector clean-up happens faster than anticipated (and more challenging, in an environment of low economic growth), why should the promise of low rates encourage investors  that they will enjoy healthy credit in the future?
- Credibility is a nebulous notion. I think the ECB has credibility to (a) not let inflation rise above 2% and (b) not let the economy fall into complete and utter chaos. I do not think they have credibility to (c) improve economic growth. I think the Fed was similarly credible in ways (a) and (b) but only gained (c) when they announced the unemployment target. But that's obviously up for argument.

2) If inflation expectations become unanchored, the ECB will have already failed. I suspect that if inflation expectations become unanchored, it won't happen in a vacuum. It will probably happen with a decline in asset prices, the Euro and possibly outright panic. This volatility is almost certain to deter investors, and harm the real economy. After all, you'd naturally demand a higher real interest rate for a riskier investment. So this could well end up offsetting any decline in real interest rates. Why not act in a resolute fashion now and just head the whole thing off?

I know, I know. Even if Draghi agreed with the above, the politics is too hard. But the only way the political balance will ever tilt that way is if the drumbeat of public opinion allows the audacious to outvote the timid. So I persist. As I said above, the review of the banking sector is both necessary and welcome. But what the Eurozone needs first and foremost is NGDP growth. Without it, promises to keep future interest rates low are a mere sideshow. As far as I'm concerned, relying on forward guidance is backward progress.

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