Sunday, 6 November 2011

Easing in

A hazard of growing older is that some events that seem fresh and relevant in one's own mind mean nothing to the younger people that one increasingly works with. So it was last week, when RebelEconomist found his forthright initial reaction ("monumentally stupid") to the cut in interest rates by the European Central Bank (ECB) at the first Governing Council meeting chaired by its new president Mario Draghi quoted by a journalist without mentioning the historical context that gave rise to it. When RebelEconomist asked the journalist why he cut out the history, the journalist replied that, since he was only three years old at the time, he did not understand its impact. The purpose of this brief post is therefore to record the historical parallel that prompted RebelEconomist's critical reaction to last week's ECB ease.

The event that last week's ECB interest rate cut immediately brought to my mind was sterling's entry into the European Exchange Rate Mechanism (ERM) in October 1990.

Hopefully even relatively young readers are aware that the ERM was a system of exchange rate pegs, with some limited movement allowed in a band around each peg, between the pre-euro European national currencies, designed to provide a stepping stone on a path from freely floating exchange rates to an irrevocably fixed set of exchange rates that would render the introduction of a single European currency a formality. To maintain their currency's position relative to the other currencies in the system, countries were obliged to either intervene in the foreign exchange market, or if necessary, adjust their short-term interest rates. Short-term interest rate changes ought to affect a currency's exchange value by uncovered interest rate parity such that, for example, raising the short-term interest rate should generate an appreciation of the currency to the point where the probability of capital loss by depreciation balances the extra interest return. Given that Germany's economy was the largest in Europe, the ERM was de facto based upon the deutschmark, and since Germany's Bundesbank had a reputation for keeping inflation low, joining the ERM effectively imposed monetary discipline on its members. If a country ran a higher inflation rate than Germany for long, incipient pressure would develop in the foreign exchange market for its currency to depreciate relative to the deutschmark, and prompt a rise in that country's short-term interest rate to maintain its currency's position in the ERM, which could be expected to suppress its excess inflation.

The mistake that the UK authorities made when sterling entered the ERM was to cut the UK's official short-term interest rate ("base rate") immediately. At the time, given the ruling party's lack of enthusiasm for European integration, financial markets were sceptical about the UK authorities' motives for wanting sterling to join the ERM. It was not hard to see that, with the base rate, used by UK banks to set their mortgage rates, standing at 15%, the imperative for the politicians then in control of UK monetary policy was to lower interest rates. However, with inflation at 10.6% and rising, a base rate cut was difficult to justify without some offsetting factor such as a stronger currency. The British authorities apparently hoped that with ERM membership underpinning the currency, the base rate could be reduced substantially while strong sterling would hold down inflation.

This sceptical market view mattered, not because it represented some character judgement about the UK authorities, but because it shaped expectations about how the UK authorities would react according to the fate of sterling in the ERM, and hence how market participants would be inclined to reallocate money in response. In particular, the suspicion was that the British authorities would be unwilling to live up to their obligation to raise the base rate if and when sterling depreciation mandated it. If so, a sensible trading strategy in the event of sterling weakness would be to sell sterling in anticipation of soon being able to buy it back at a depreciated level after the UK authorities abandoned their commitment to the ERM.

Against such a background, the worst thing that the British authorities could have done would be to feed market scepticism by cutting the base rate hastily (unless a cut was mandated by sterling approaching the top of its band against one or more of the other ERM currencies). Unfortunately, that is exactly what the British authorities did. In fact, they announced a 1% cut in the base rate at the same time as they announced ERM entry, after financial markets had closed on Friday 5 October 1990, and therefore even before sterling had traded in the ERM. Although sterling did appreciate when markets reopened on the following Monday, by the end of the month sterling had depreciated below its peg to the deutschmark even with no further cuts in the base rate. The stage was set for a disappointing time for sterling in the ERM from the UK authorities' point of view, with sterling generally trading in the weak half of its ERM bands, preventing the base rate being cut below 10% despite a dramatic fall in inflation to under 4%, and culminating in the infamous Black Wednesday debacle of 16 September 1992, when despite a reported $27bn of foreign exchange intervention and a 5% increase in the base rate, the UK authorities were unable to hold sterling within its ERM bands and were forced to withdraw it from the ERM.

As a novice central banker at the time, the conclusion I drew from the ERM experience was that, if a change in monetary policy regime removes an obstacle to easing, even if easing can be justified, it is best not to ease at the first opportunity that the new regime presents, especially if the market suspects that the new regime might be softer on inflation. Better to show patience, and prepare the ground for a shift in the monetary policy stance. A delay of a month or so to skip at least one monetary policy meeting should not be a problem, because if the need for easing was that pressing, it would have no doubt been warranted under previous policy regime too.

A similar situation faced Mario Draghi last week at his first meeting of the ECB's Governing Council as ECB President. As an Italian, it was inevitable if perhaps unfair, given Italy's reputation for weak currency and large public debt, that Draghi's commitment to low inflation would be questioned (commenting on Draghi's candidacy for ECB President, the German newspaper Bild wrote "for Italians, inflation is a way of life like tomato sauce with pasta"), notwithstanding some hawkish comments he has made in recent months. In spite of this suspicion about his intentions, Draghi allowed, if not actively encouraged, last week's Governing Council meeting to cut the ECB repo rate – we are told that ECB monetary policy decisions tend to be decided by consensus rather than majority, so we can be sure that Draghi at least did not block the change. Worse, this decision came as a surprise to the market, partly since there was little sign of support for reducing the repo rate from the previous Governing Council meeting on 6 October – according to Draghi's predecessor Jean-Claude Trichet's account of that meeting in reponse to media questions, "the Governing Council found short-term interest rates to be low" - and partly because eurozone inflation presently stands at 3.0%, clearly above the ECB's target of "below but close to 2%". In view of the situation, I would say that Draghi's decision to cut the ECB repo rate last week was a tactical mistake. Draghi's action will have reinforced the market's suspicion that he will be relatively soft on inflation.

Fortunately for Draghi, the impact of his rash interest rate cut on market expectations seems to have been small – medium term (ECB presidents are appointed for a maximum term of eight years) euro area breakeven inflation rates, such as derived from five year German bunds, ticked up only a few basis points on the news. Nevertheless, such inflation expectations represent an average over a wide range of realisations of economic circumstances, and there may yet come a time when eurozone inflation is uncomfortably high, and to get it down Draghi might find it necessary to tighten monetary policy more than an ECB President who was believed to have a stronger commitment to low inflation.

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