Tuesday, September 29, 2009

Don't expect the time for an ECB exit to come soon

I frequently highlighted that narrow money aggregates are rising but broad credit aggregates are not as banks are unable/unwilling to lend and borrowers unwilling to borrow. In turn, the velocity of money decelerates and we remain in a state where there are too many goods and not too much money. In turn, remaining price pressures are weakening and core inflation will continue to drop in the months and quarters ahead. Just last week I stated that the combination of falling M3-M2 and even more so M2-M1 coupled with a limited addittional balance sheet lengthening by the ECB vs. a "normal" course of action add further weight to the argument that even medium-term inflation pressures in the Eurozone appear very limited as the money being created by the central bank does not find its way into the broader economy (see Where are the inflationary pressures in the Eurozone's monetary developments).
Since then the ECB has released the data for monetary developments in August. M3 grew by a record low since the launch of the euro of only 2.5% yoy. However, I think that looking at M3 alone does not provide the whole picture. Rather, we should look at M1, M2-M1 and M3-M2 separately.
M1 rises but M2-M1 and M3-M2 continue to fall

Source: ECB, ResearchAhead

As the chart above shows, M1 (the sum of currency in circulation and overnight deposits) continues to rise at a fast pace. However, M2-M1 (deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months) is falling further as is M3-M2 (repurchase agreements, money market fund shares/units and debt securities up to two years).

Yesterday, ECB president Trichet stated in the hearing at the Economic and Monetary Affairs Committee of the European Parliament (full speech here) that "The assessment of low inflationary pressures over the medium term is also confirmed by our monetary analysis. In this context, we note in particular that money and credit expansion continues to decelerate. The annual growth rate of the broad monetary aggregate M3 declined to 2.5% in August, the lowest reading since the launch of the euro. As regards lending to the private sector, the annual growth rate of loans virtually stalled in August (at 0.1%)."
Furthermore, with respect to the timing of any exit strategies he said: "The Governing Council of the ECB considers that it would be premature to declare the crisis over. Now is not the time to exit. However, at some point in time exit strategies will have to be implemented. The ECB has an exit strategy and stands ready to put it into action when the appropriate time comes. Our exit strategy is an integral part of our overall monetary policy strategy. This means, in particular, that if we judge that the non-standard measures trigger risks to price stability, we will unwind them."
And finally with respect to potential inflation pressures he goes on: "The second point I would like to emphasise concerns the relationship of liquidity and price stability. Some commentators ask whether our bold programme of liquidity provision could ultimately trigger inflation in the future. Let me explain why this fear is unfounded. To start with, it should be noted that although the liquidity provided by the ECB has increased substantially, this has not led to an increase in monetary aggregates. This would have been the case in normal times when banks use an increase in our liquidity provision to create credit to households and enterprises. However, at present this does not appear to be taking place on any significant scale. As I mentioned earlier, the growth in monetary aggregates – an overall important measure of liquidity expansion in the economy – is at its lowest level for at least a decade. Furthermore, it should be noted that the ECB has all the instruments required to promptly withdraw its liquidity support if necessary, to counter the possible emergence of upside risks to price stability. It helps in this context that most non-standard measures are being phased out naturally, as the operations stop at maturity, unless we decide to extend them."

I completely agree with president Trichet's statements. The rise in narrow money aggregates is not inflationary as it does not lead to a significant growth in broad money and credit aggregates. Once this will take place, the central bank will likely exit their exceptional liquidity support measures and thereby draining excess liquidity. Clearly, the timing of such an exit is key, but I still remain convinced that there is an equal risk between exiting too early and exiting too late. Furthermore, I am convinced that as long as M3-M2 and even more so M2-M1 is not growing on a sustained basis, any exit will be premature! At present, not only are M3-M2 and M2-M1 falling, but the drop is still accelerating! If we look at the annualised 3m percentage changes in the various aggregates, we can't even talk of a stabilisation in the drop of the aggregates. As the table below shows, the 3m annualised change in M2-M1 stayed at its record of -10.5% in August and reached a new record low of -22.4% for M3-M2!

3m annualised growth rates of monetary aggregates (seasonally adjusted)






Aug 08






Sep 08






Okt 08






Nov 08






Dez 08






Jan 09






Feb 09






Mrz 09






Apr 09






Mai 09






Jun 09






Jul 09






Aug 09






Source: ECB, ResearchAhead

Yes, the credit easing operations of the ECB are working in that they have led credit-related yields significantly lower again. This is a necessary condition for the monetary transmission mechanism to work again. However, it is not a sufficient one. As the development of M2-M1 and M3-M2 shows, monetary aggregates continue to shrink significantly. We also need renewed growth in these aggregates before the ECB should contemplate an exit from their exceptional monetary policy measures. I am convinced that we are still far away from the need to do so and do not regard an exit as likely before H2 2010!

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