The deflation threat wasn’t the only reason for the surprise ECB rate cut

The ECB’s unexpected move to cut rates this week has been blamed on the fear of deflation. The October data release showed price rises of only 0.7%, less than half the 2% target and way below expectations. Draghi clearly does not want the Eurozone turning Japanese but stressed in the presser that it was not likely and the situation is different. However an alternative view is to blame the cut in rate on the appalling state of Europe’s banking industry. The conspiracy theorists are linking the decision to the ECB’s current investigations into the eurozone banks’ financial health (ahead of regulatory supervision in a year’s time). The argument is that the ECB has found out that the mess is nastier than it thought and so cut rates further to help (albeit under the cloak of deflation).

I am not a conspiracy theorist, but there are a few things about this story that make it interesting.

First of all, the most recent economic data from the eurozone has been strengthening (albeit modestly). Business surveys are indicating an upturn. The US, the largest economy in the world whose prospects influence Europe greatly, reported a startling good 3Q GDP figure of 2.8% this week. Add on a strong NFP number on Friday and one wonders at the timing of the ECB. Also remember that monetary policy has a time delay lag on inflation of at least a year according to work done by the legendary economist Milton Friedman in 1972. So why cut now given the data is getting better and any impact on inflation is a year away anyway?

Secondly, there was much debate in equity markets on Thursday about whether the ECB’s new stress tests on Europe’s banks would result in taxpayers having to pick up the bill for recapitalising the weak ones. The German government denied this was the case – the Finance Ministry said that protection of taxpayers is “of central importance”. The ECB on the other hand wants to centralise failing lenders and published a piece on its website on Friday setting out its position. It sees a Single Resolution Mechanism with a “strong and independent” authority with a central fund “financed ex ante by the banking sector”. Who decides on what is a failing bank, how it gets resolved and who pays for it are the contentious issues (and of course the key is in the ex ante, because someone has to pay for it now and it won’t be other banks). Whether we get an agreement on any of this by year end is uncertain. Finance Ministers are meeting in Brussels next week and will be discussing it in depth.

And the news from selected parts of the banking industry has been poor this week. In my inbox on Thursday arrived a summary of Fitch’s report on the Spanish property market. It said “sales of Spanish residential properties that have been repossessed by lenders are on average 71.6% lower than their original valuations”. Wow. According to Fitch Director Carlos Masip, there is still a huge supply demand mismatch with 1.72 million homes for sale in 2012 and only 259K actual sales. The suggestion is that much development land is worthless.

In Italy the latest data suggests that its banks are still heavily reliant on ECB funding. The Bank of Italy’s data show that for October the ECB funding to Italy’s financial groups was at E235.4bn. It also suggests that Italian banks are using LTRO money to buy Italian sovereign debt. LTRO cash is not being used to lend to the real economy.

And in the regular Tuesday ECB updating of Eurosystem weekly liquidity, the Emergency Lending Assistance increased to €80.406 billion, up over €3 billion from the week before and still stubbornly high. It is a reminder of the weakness still present in the Eurosystem.

So plenty of news this week about the eurozone’s troubled banks strengthens the Conspiracy Theorists view. But the final argument against a cut for fear of deflation is that I think the only way out for the UK, Europe and the US is inflation. Earlier this week I was presenting at a Family Office conference and it confirmed my view that inflation is on its way. I cannot see that there is any exit route for indebted governments other than to inflate their problems away. It is the only way for the UK, US and eurozone to get rid of their debt.

If you look at the options:

  1. Default on debt outright and become Argentina
  2. Payback less and later (an effective default) and become Greece
  3. Default on promises made to citizens and impose austerity and become Ireland
  4. Or governments can aim for inflation to reduce the real burden of the debt.

Now the key is that the top three options are vote losers and the last is the only one that is a potential vote winner. Why? Because inflation increases asset prices. So for a country like the UK, with large property ownership, then asset prices rises please voters. It takes time for voters to understand that inflation is seriously damaging to their wealth.

So I don’t buy into the deflation threat, quite the opposite. I fear Draghi, Carney and Yellen will ignore the starting signals of inflation for far too long.

The above arguments suggest I am siding with the Conspiracy Theorists which is not a position I am comfortable in. But does it matter why were rates cut? The deflation scare or help for Europe’s troubled banks? The move was lauded by many commentators and bourses and bonds both bounced. But a 0.25% rate cut is pretty meaningless when rates are so low. It is unlikely to increase credit and make much difference to the economies of Europe. The ECB publishes its updated growth and inflation targets after the December 5 meeting and so many had expected the ECB to cut then. Maybe it was just the surprise. andDraghi wanting to be “ahead of the curve”

But what to me is interesting is that the Conspiracy Theorists did link the rate cut to the ECB’s bank stress tests. That to me highlights the important assumption market players are making – that any help given to Europe’s banking sector will need to be done surreptitiously. The environment of banker bashing ensures taxpayer funded bank bailouts are a complete no no. So where will the cash come from to recapitalise the EZ’s weakest banks (once the ECB has done the numbers)? Expect the source to be well hidden. Helping banks is a complete vote loser.

So what has Draghi achieved? To me his risk reward was not great. He will achieve little economically with the cut but his downside is that he has signalled he has run out of options. But maybe as a central banker, it is more important to be seen to do something than not. And that was what this rate cut was all about: SuperMario to the rescue: