Trying to keep a financial system and a currency union from collapsing upon each other.
By Don Quijones, Spain & Mexico, editor at WOLF STREET.
To the ECB’s barely contained glee, inflation is back, alive, kicking and biting, in the Eurozone. In February, for the first time in four years, the region-wide 12-month inflation rate reached 2%.
Mario Draghi is thrilled to bits. After five years of driving interest rates to ungodly low levels, offering billions of euros of virtually free loans to Europe’s biggest banks, and scooping up tens of billions of euros per month of government and private-sector bonds and stuffing them onto the ECB’s balance sheet, which now holds €3.7 trillion of financial assets, he has finally achieved his dream of stoking official inflation back above 2%.
Now that it’s achieved its inflation mandate, Draghi’s ECB is facing increasing calls to finally begin tempering its monetary stimulus program, with a pre-electoral Germany predictably leading the way.
“It would probably be right if the ECB starts daring to head for the exit this year,” Germany’s Finance Minister Wolfgang Schäuble told the Sueddeutsche Zeitung newspaper (emphasis added). That was in January, when inflation in Germany was still below the 2% mark. Now it’s at 2.2%, its highest rate since August 2012.
In Germany inflation matters a great deal, for two main reasons. First, it is a nation of savers and renters. If inflation rises, so, too, do rents while the purchasing power of the people’s savings falls. And if wages cannot rise as fast as inflation, purchasing power of those wages shrinks.
Second (and probably most importantly), the mere prospect of inflation tends to stir painful collective memories of what happened in 1923, when the country suffered one of the worst episodes of hyperinflation ever recorded. In less than a year, Germany’s currency became worthless. Poverty and hardship spread like wildfire as the value of people’s savings and fixed incomes was completely wiped out.
The psychological scars of this collective trauma live on to this day. When, in May 2012, Schaeuble and Bundesbank economics chief Jens Ulbrich suggested the country could live with slightly higher inflation — at the time it was just above 2% — the daily tabloid Bild screamed an immediate response from its front page: “Inflation Alarm!” Accompanying the headline was a photo of a trillion-mark note from the mid 1920s.
This time, in an effort to head off such fears, the Bundesbank has begun dropping gentle hints that the ECB might want to begin changing course sooner or later. “Once price developments are sustained, they will provide the foundation for an exit from loose monetary policy,” said Jens Weidmann, the Bundesbank’s president. The ECB’s “expansionary monetary-policy path is currently appropriate” given the still-moderate inflation in the 19-country region, he added. That was at the end of January. Since then, inflation has continued to rise throughout the Eurozone.
In Spain it was 3% in both January and February, having almost doubled from the 1.6% rate recorded in December, 2016. The last time it was that high was in October 2012. The biggest mover in January were energy prices, propelled by rising global prices as well as regulatory changes, while in February the biggest driver was food prices, with fresh fruit alone surging 7.6%.
In Belgium the inflation rate is now also on the verge of breaking through the 3% mark. In the Netherlands, the inflation was 1.8% in February; in France and Finland, it was 1.2%, and in Portugal, 1.6%. Even in Italy, whose economy is still threatened by an industry-wide banking crisis, inflation reached 1.6% in February. Four months ago, it was -0.1%.
But the last thing Italy’s government or national central bank wants is for the ECB to begin withdrawing the monetary stimulus. If the ECB stops buying Italian bonds, who will pick up the slack? The answer is no one.
This may explain why Bank of Italy Governor Ignazio Visco is now warning of “higher risks” for the Eurozone resulting from the “accentuation of a climate of uncertainty and pessimism.” In January he urged the ECB to maintain the “highly accommodative monetary conditions,” to ensure “price stability,” by fueling rising prices.
Visco has every reason to be concerned of a change of ECB policy. If the central bank begins tapering, and investors get wind that it is buying fewer Italian bonds, investors will begin selling, triggering downward spiraling prices and rising yields. In a repeat of 2012, Italy’s government will start having difficulty servicing its debt, which will merely serve to exacerbate the sell-off.
Despite the ECB’s QE program, the biggest holders of sovereign bonds are still European resident banks, reports Breugel. In other words, the Doom Loop is still intact, just waiting to be set in motion. In fact, by providing banks with an endless supply of virtually free money with which to buy up obscene amounts of Eurozone sovereign bonds, which ’til now have been backstopped by the ECB’s QE program, the ECB has only amplified the incestuous co-interdependence between sovereigns and their banks. Hence, a sovereign debt crisis instantly become a banking crisis.
In Italy the government now is seeking to expand its own debt in order to bail out Monte dei Paschi di Siena and a clutch of mid-sized banks, whose balance sheets are no doubt filled with Italian government bonds.
In the end, the ECB’s policy isn’t just about creating inflation but about keeping a financial system and a poorly conceived currency union from collapsing upon each other. And now they are more dependent than ever on the constant drip-feed of monetary stimulus. By Don Quijones.
Germany loves physical money and paying with it. This is a big problem for a European establishment desperate to consign physical money to the scrap heap. But the ECB would do so at its own peril. Read… Are Germans About to Be Made to Pay for Their Love of Cash?
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.