Followers of US monetary policy are raising concerns about the consequences of the Federal Reserve’s efforts to reverse the 17% growth in the money supply (M21) in the two-year period starting from the emergency Covid liquidity measures, March 2020. In the last twelve months this injection has all but been removed from the system, leading to concerns that the US economy is being starved of funds and cannot grow. What about Europe?
The ECB, which seems primarily concerned with its 2% inflation target despite fifteen years of minimal economic growth and the constant deterioration of Europe’s manufacturing base, recently addressed similar concerns about the growth of broad money. Although Euro Area M2 reduced steadily in the year to August, it rebounded a little in September and presently is equivalent to about 100% of GDP (€15 tn).
Recent ECB Policy Analysis in respect of Money Supply
Isabel Schnabel, Germany’s representative on the ECB Executive Board, observed in September that since the COVID outbreak the Euro Area’s money supply expressed as M12 increased by 30%3. She noted that Euro Area inflation had risen during the 2020-2022 period from 1.2% to 9.1%. However, she denied any causal relationship between money supply growth and inflation. The main purpose of her speech was to explain why central banks have “relegated the analysis of monetary developments to the background”. She focused on two main points:
- Firstly, although conceding that there is plenty of empirical data over long periods of time showing a linkage between the supply of money and inflation, she opined that the linkage only works when extreme inflation shocks, such as the world wars, oil crisis in the 1970s and the recent energy price shocks are included in the time series. Put differently, the ECB’s view is that in periods of low and stable inflation the relationship weakens and therefore there is no causal relationship between money supply changes and inflation.
- Secondly, in asserting the value of a mix of ever adjusting policies Ms Schnabel cited Goodhart’s law – when a measure becomes a target it ceases to be a good measure. To reinforce the point, she noted the new approach to economic modelling at many central banks which excludes analysis of money supply.
Finally, she boasted that “the ECB’s determined tightening of monetary policy had an imminent and significant effect on monetary dynamics, supporting disinflation.” Nonetheless she appears to be saying that whilst monetary loosening does not cause inflation, monetary tightening is effective in reducing it.
Our 2024 Forecast – Euro Area Recessions and Challenges for Banks
The purpose of Ms Schnabel’s speech was to reassure that there is not too much to worry about. Some data are supportive. Eurostat reported that inflation fell in October to 2.9% from September’s 4.3%. This initially bolstered ECB credibility with markets as hopes rose that interest rates could be lowered. It was also welcomed by politicians, given the widely known fiscal strains of servicing public debt. However, shortly after this good news, ECB president Lagarde surprised markets on November 10th by warning that the current reference rates are unlikely to come down for the next couple of quarters. Markets reacted badly amid fears of recession.
And there is reason to fear recession. Euro Area GDP contracted by 0.1% in Q3, and Eurostat’s October GDP expectation is for further contraction. What if this develops into severe recessions and full-blown stagnation? We are not alone in considering that by keeping rates this high whilst even modestly reducing the money supply, this outcome looks increasingly likely. An economist at Unicredit was quoted as saying “the size of the ECB’s tightening may go down in history as the third European policy mistake during the past 15 years”. Former ECB President Draghi shares these fears4:
“It is almost certain that we are going to have a recession by year end. It is quite clear that the first two quarters next year will show that.”
A recession will be very challenging for banks. Demand for new loans in the Euro Area is at the lowest levels since the financial crash of 2008-09. Existing loan books are hardly strong, and weakening household and corporate finances will further hurt banks, whose boards and supervisors are already very concerned about non-performing exposure (NPE) levels. Even the ECB’s bank supervisors drew attention to precisely such concerns in their end-2022 Supervisory Review.5 A recession will surely increase NPEs as well as Euro Area imbalances such as Target2 and other possible centrifugal forces at play within the euro area. This could become politically tense; populism remains on the rise.
We also expect banks to face competition in defending both their deposit bases and their higher quality lending businesses. Digital banks will likely continue to lure away depositors with better interest rate offerings. Money market funds are also proving popular with European savers for the same reason. Europe’s banks were already experiencing net deposit withdrawals earlier this year even before rates reached their present highest levels6.
Moreover, a new competitive threat to deposits could come from European car manufacturers. Unhappy that capital market funding costs for corporate bonds and loan securitizations have risen sharply, car companies are tweaking their business models by offering sweetened terms to buyers willing to put down large deposits on which generous deposit rates are paid.7
If it transpires that the ECB is mistaken in forecasting Euro Area growth from now and through next year, then the ECB may be forced to make an embarrassing emergency pivot, slash interest rates and pump liquidity into the system via new quantitative easing. Inflation targeting will be declared less important than allowing any member state to default on its sovereign debt. None of these outcomes look good for banking. Global regulators have already published the ‘final’ iteration of Basel, which of course envisages higher regulatory capital and liquidity levels. There must be serious doubts as to whether Europe’s banks will be able to cope.
Of even greater concern for the ECB will be the recent public comments of former President Draghi, who recently warned8 that the EU itself cannot survive unless meaningful growth is restored after 20 plus years of the euro, whose economic impact Europe’s leaders have consistently failed to understand.
Of course, the bottom line is that the real problem is government intervention in the money and financial markets: it creates distortions, illusions and eventually crises. Looking for the right “model” and for the skilful central banker won’t do: one is alchemy, the other is an oxymoron. And fiscal policy adds to the mess.
1 The sum of currency held by the non-bank public, plus checkable bank deposits, plus savings and deposits and small time deposits (see the Federal Reserve Bank of St.Louis at https://rb.gy/7sy2to)
2 The sum of currency held by the non-bank public plus checkable bank deposits
4 Speech at a Financial Times forum, London
8 FN 5, Ibid
Photo by Mika Baumeister