Searching hard for Taylor’s inflation

In February 2011, I was in the audience of a lecture given by John Taylor on the “exit strategy”. One main theme was that the policy of the Fed called “Quantitative Easing” meant a high risk of monetization and inflation, if not hyper-inflation, in the U.S. economy. In the Q&A session, I asked Professor Taylor why he thought that “monetization” is inflationary. I argued that Quantitative Easing boils down to portfolio shifts in banks’ balance sheets, and that asset reallocation does not seem to be causing an increase in demand, nor a price increase. His answer (that I quickly noted in every detail on a piece of paper) was:

John Taylor’s answer: We do have theories that connect money to inflation. Yet, it is not simply this channel. it could be expectations. When excess reserves translate into money supply expansion, inflation becomes a risk. At that point, the Fed should reduce its balance sheet, but the question is how long will it take? Also, QE makes financial markets aware of a signal that interest rates will remain too low for too long. And please don’t forget the international effect: Emerging countries will find it more difficult to raise their own interest rates to prevent inflation, so inflation may spread from there. The inflationary effect of QE is not instantenous, although we begin seeing it now in commodity prices. In any event, inflation risk remains a concern.

The fact is that since John Taylor’s strong forewarning of rising prices, and after a lot more QE by the Fed, U.S. inflation has always been lower than it was at the time he delivered this speech. Three and half years later (see Chart), we don’t yet see evidence of John Taylor’s feared inflation.

PPI 2011-2014

Letter to The Economist

SIR – You described the ECB as moving forward at “breakneck speed”, while businesses and workers in the Eurozone are not doing likewise (“Busy, busy”, September 4th). But more should be said about the trajectory along which the ECB seems to be advancing so quickly. As the ECB embarks on QE, you note that the ABS market is “simply too small” to boost growth and the sovereign bond market, while large enough, is politically unfeasible.

I would raise a more fundamental question: What does the ECB expect to achieve by removing (from banks’ balance sheets) assets carrying positive yield and replacing them with “reserves” (that now yield a minus 0.2%)?

The notion that QE encourages bank lending and that reserves multiply into bank loans is flawed. A number of academic and practitioner articles have dispelled the myths surrounding money creation and QE. If this is true, then the ECB may be moving at “breakneck speed” toward a brick wall.

Negative EONIA rates are not *cracks* in the banking system

From Reuters: UPDATE 3-Negative euro overnight rates show cracks in banking system

While there are many signs of cracks in the Eurozone, European banks “paying” negative rates to other banks for lending money is not one of those. It is simply the profit-maximizing consequence of the ECB’s decision to charge banks for any reserves above the required minimum.

What happens is the following:

Bank A (short of liquidity) must settle a payment with Bank B for one million euros. This means Bank A must send one million to Bank B. If Bank B believes they have enough liquidity already, they will carefully consider the consequence of being credited one million and being charged a negative annual 0,10% by the ECB.

A better alternative for Bank B is to ask Bank A not to send the amount due, and be paid a fraction of (up to) 0.10% for borrowing it.

See the Q&A on negative rates.

Fiscal responsibility means quality spending and the “right” deficit

A response to Steve Hanke’s defense of austerity

Since the outcome of the European elections, political leaders in the EU’s most stagnating countries have been calling for an end to austerity. While they seem unable to develop a realistic and politically palatable alternative, Europe remains in the doldrums, and pro-austerity views are having a comeback. One such example is Professor Steve Hanke’s defense of austerity (in “The EU’s Anti-Austerity Hypocrites” which aims at reasonable objectives with the wrong tools.

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ECB drives rates below 0.05%: And now what?

The move of the ECB on June 5 was primarily aimed at restoring conditions of low and stable money market rates.

It was not difficult to predict (as I did here six weeks ago) the direct consequences of the new official rates and, notably, of the prolongation of fixed rate, full allotment tender procedures, and of the decision to suspend the weekly fine-tuning operation sterilising the liquidity injected under the Securities Markets Programme.

Except for the end-of-June spike, money market rates appear more stable and lower.


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Eurozone liquidity conditions: Still a bit tight in the midst of plenty?

Mario Draghi’s “historical measures” (as defined by Bloomberg) are best seen as ways to restore the interbank rate of interest (EONIA) that prevailed throughout 2013, when the interest rate that banks paid each other for lending and borrowing liquidity (aka “reserves”) had stabilized a few basis points above zero.

This rate is the main policy-driven rate that shapes all money market rates. A super-low and stable EONIA had been the outcome of two ECB measures in 2012: the VLTROs and the Deposit Facility rate cut to zero.

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ECB: What are negative rates for?

As of 11 June 2014, the interest rate on the Eurosystem Deposit Facility is -0.10%. This negative rate applies to all banks’ holdings of euros in excess of the minimum reserve requirements, as well as to cash balances above a certain threshold that Eurozone governments hold in the Eurosystem (this is cash obtained through taxes or bonds issued and not yet spent), as well as to all deposits held by non-Eurosystem central banks.

What does it mean that the ECB sets a negative interest rate?

In the same way as an interest paid by the ECB to holders of euros is a net addition to holders’ income, an interest paid by the banks to the ECB for holding euros is equivalent to a tax on holders of euros.

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ECB: Where is the news? (so far)

Has the ECB lowered interest rates at historical low?

Not exactly. The rate goal of the ECB is the interbank rate (called EONIA). This has always been below 0,10% in 2013.  The problem was that as banks began early repaying their LTROs, EONIA went above 0,10% in 2014. Thus, today’s move is simply an attempt to pull EONIA down to below 0,10% and stabilize it there, if possible.

Is the negative rate on the Deposit Facility big news?

Given that the ECB will apply, as of June 11, a negative rate on ALL excess reserves (Deposit facility AND Reserve account), and given that the ECB is expanding excess reserves by ending SMP sterilization, my early considerations on the effects of negative rates apply.