Some unpleasant Quantitative Easing Arithmetic

Some 30 years ago Thomas Sargent and Neil Wallace published an article [1] that raised the possibility of tight monetary policy leading to inflation. Salvatore Rossi and I showed that this result was due to a questionably formulated public budget constraint in their model [2] and basically salvaged the traditional result that it is loose monetary policy that leads to inflation.

The link between that old story and Quantitative Easing is that there is something unpleasant about Quantitative Easing arithmetic, at least for those market observers that, with some justification, interpret recent ECB message as pre-announcement of some exercise of this sort.

Is the €-area in 2014 like Japan on the dawn of deflation?

If you are impatient and somewhat trust my judgment, let me give first my synthetic answer to the title question: out of the five criteria I use to compare the current situation in the €-area to that in Japan at the end of the ´90s, two (current situation of the banking sector and inflationary expectations) do not indicate that the €-area is in a better position than Japan when it was about to enter its deflationary period. On one other criterion (central bank activism) there is a slight advantage for the ECB. On the two last criteria (the prospective cleaning up of the banking sector and demography) the situation in the € area is clearly better than it was in Japan. Overall, my sense is that, in particular taking into account the recent hesitations of the ECB to confront too low inflation, confirmed in the last press conference, and the now weakly anchoring of inflationary expectations, one cannot exclude a significant risk of Japanification for the €-area.

From firmly to weakly anchored, or the importance of an adverb!

Four months ago I published a post with the title: Is the price stability target of the ECB at risk? In it I explored the risk of inflation remaining too low for too long in the €-area.

My conclusion was: ”yes, there is a risk for the price stability objective, but the probability of this unfavourable development is low if the ECB will use its tools appropriately.” In light of the lack of action by the ECB in March, even when projecting inflation remaining well below its objective of “close but below 2.0% in the medium run” for the fourth year, it is useful to review the issue and update the answer.

Should the European Central Bank do more and go negative?

The European Central Bank is torn between those who say that it is already doing too much, mostly in Germany, and those who say it should do more. One of the actions the ECB should pursue, in the opinion of the latter group, is to bring the deposit rate into negative territory. 

Is the price stability target of the ECB at risk?

Get me right. I am not fearing, for the time being, that inflation will move above the 2.0 per cent ECB target. Of course, it would be wrong to assume that inflation is dead and can never come back and the central bank must be symmetrically alert to all deviations from price stability. Too high inflation is not, however, the risk against which to guard in the foreseeable future. The issue I want to explore here is whether there is a risk of inflation remaining too low for too long. This issue is germane to the risk of "Japanification", which has started to be discussed in the market.

Forget the € and demand management!

The title of this post is a bit exaggerated, yet it helps stressing the gist of the point I want to make: policy makers, market participants and ordinary citizens should start devoting less attention to the € and to demand management and should concentrate, instead, on supply issues.

Let me expand a little this basic idea.

Cimabue and Giotto, the Bundesbank and the ECB: an analogy?

Cimabue is defined by the Encyclopaedia Britannica as “the last great Italian artist in the Byzantine style”, while in the web-site of the Louvre one reads that Giotto "has been seen down the centuries as the instigator of a painting revolution without precedent since ancient times". Dante Alighieri in his Divina Commedia so defines the relationship between the two painters: “Credette Cimabue ne la pittura tener lo campo, e ora ha Giotto il grido, 
sì che la fama di colui è scura”, which can be translated in English as “Cimabue thought to hold the field in painting, and now Giotto hath the cry.”