Author Archives: ifund

Looking For Some Oil? Get Deflation for Free

It does not take to be a financial or economic expert to know that the Eurozone is gradually but confidently sliding into deflation. According to Eurostat, in December 2014 inflation has crossed the “red mark” of 0 percent, obtaining a negative value for the first time in quite a while. Why?
The prime reason for this is the falling oil price. With prices of oil that have shrunk by more than half, compared to 2013, production now has become a lot cheaper. This, consequently, pulls the final prices of products down as well. A point that becomes even more obvious, when the value of the so-called “core” inflation is considered (the level of prices excluding prices of food, energy, alcohol and tobacco). Whilst the overall level of inflation is around -0.2%, the level of the core inflation is still above zero, even though only marginally: 0.8% (Eurostat).

In the US the story is pretty much the same. Being seriously dependent on the imports of oil, and to a lesser extent on the prices of goods from Europe, the economists from the Fed should really get their heads round the problem. With the oil imports accounting for 7.8 per cent of all the imports, such a severe plummet in prices could not leave the levels of inflation unchanged.

The question is: why deflation is bad at all? At first glance lower prices, given the same income, mean increased purchasing power, which is certainly not a bad thing at all. The only amendment here: if deflation does persist. However, when inflation is below zero for a considerable period of time, the constantly falling prices push people towards consuming less today, because tomorrow prices will be even lower still. This sets consumption down, which in turn damps GDP, and it goes all over again, until the equilibrium is reached at a lower level of output (sounds familiar, right?).

Also, deflation affects lenders and borrowers. If you borrow 100 EUR today, and have to return it in a year, the person who lent it to you will certainly be happy about some level of deflation (because then, 100 EUR in a year would be worth more than they do now). Clearly, though, you would not share the happiness of that person all that much. If you take it to a broader scale, debtors might end up in a serious trouble (yes-yes, Greeks probably do not like deflation very much, but it has to be said that inflation would not solve their problems, either)

At this point, every SSE Riga student can infer that if the prices are too low, why not inject more money in the economy? Apparently, chaps at the ECB must have thought of the same thing. They are now planning to inject 60 bln EUR every month from March 2015 to September 2016 by buying Eurobonds. They do that, but at the same time they still remain very cautious about it. Firstly, it might result in an unfair distribution of money in the society. Secondly, it reveals the biggest issue of low inflation: the liquidity trap.

As we all know thanks to Morten, the liquidity trap is a situation in the economy, when the government tries to increase the monetary supply, pinning hopes that it will decrease the interest rates and boost investments, but due to the fact that the interest rates are low already, the target is not actually met.
Here we need to introduce the notion of the real interest rates. The real interest rates are the nominal rates less inflation (this relationship is often referred to as the Fisher equation, after a famous American economist Irving Fisher). They show the real interest that people can expect on their saving, excluding the impact of inflation. When inflation is low (or indeed negative), the banking system cannot push the real rates low enough to stimulate investments, because the nominal rates cannot go below 0 (otherwise people would have to pay for saving, which is of course ridiculous).

With all this in mind, it seems that trying to battle deflation with monetary policy measures is not something that is capable of turning the Eurozone to its former prosperity. For a moment it looks like the fiscal policy measures could cope with the job better (anti-austerity measures, etc.)

After all, when most of the European countries have managed to cope with the economic pique of 2008-2009 maybe it is time to go further? This would mean increasing government spending, reducing taxes and trying to defibrillate the suffocating economy in the good old ways.

Why nobody does that? There are many possible explanations. To put it short, the reason most likely stems from political and geopolitical situation. Because when the world is on the brink of maintaining social stability, fighting wars, suffering from terrorists, and battling social inequality, nobody is willing to take their chances.

Will Quantitative Easing Save Europe?

On Thursday, the European Central Bank has published Account of Monetary Policy Meeting. The largest topic that now is being discussed is Quantitative Easing (QE). It assumes purchases of European bonds, mostly governmental. The mechanism works by the indirect influence on the overall interest rate level through lowering the yield of government bonds.


Base money M0 in Euro area (millions of Euro)

We all can understand how quantitative easing works, recollecting our lectures in macroeconomics.The Central Bank buys bonds from banks and increases demand on them, which leads to appreciation in price. The increase in bonds’ price means lowering the interest rate, and this effect should transpose to the whole economy. The difficulty is that the demand for bonds is already very high, because banks see too high risks to invest in the private sector, so for the central bank it is too unprofitable to buy bonds with an almost negative interest rate.


Money suppy-demand equilibrium increases

As we know, the monetary base M0 increases when central banks issue more money to shift the LM curve to the right in the ISLM model. Increasing M in money demand−supply equilibrium condition
L = M/P increases money demand, and the LM curve shifts. Ideally, we assume a movement along the IS curve, which represents all equilibriums in the goods market, to the lower interest rate, which relates to a higher GDP level. Therefore, we can expect the third significant increase in M0, which is represented by the red graph.

As ECB Quantitative Easing package shows, they are planning to buy government bonds for €60 bn a month during the whole program. This significantly exceeded market expectations despite some insiders noted that this amount would be €50bn monthly “because purchasing more assets sooner would “accelerate the impact” of QE.” Moreover, this program will go in addition to previously introduced methods of fighting small amount of new credits and the growing threat of a deflationary downward spiral.
The previous instrument ECB used for lowering borrowing interest rates was TLTRO, Targeted Long−Term Refinancing operations. It was a program of cheap long−term loans at the interest rate of just 0.15% to the largest commercial banks. These loans could be issues to businesses and households for 4 years or even more, if these are successful project, but cannot be given to purchase the real estate to avoid another realty bubble as in 2007. This program has been partly successful. The Governing Council of the European Central Bank notes that “The targeted longer-term refinancing operations (TLTROs) had contributed to a further decline in bank lending rates across the euro area, thereby easing borrowing conditions for firms and households.” However, everyone agrees that the expectations of banks’ desire for more liquidity have been overestimated: “The total estimated take-up over all eight TLTRO operations was significantly lower than envisaged in September 2014.” The first transfer in September 2014 resulted in taking loans of €82.6 bn, and in December €129 bn were allocated. Despite that, the total amount of €212 bn is very far below the initial 400 billions that were expected to be taken by banks in 2014. Many experts agree that the modest cheap loans’ appetite is the main reason of the dramatic change in ECB policy, which include QE of such a scale – ECB has not reached the expectations of lowering interest rates in public sector, and has now decided to operate independently from commercial banks, using the mechanism described previously. This situation cannot be called positive for the economy, because it was expected that the full amount of TLTRO will increase GDP of western European countries approximately by 0.3%.
At the moment the real GDP of 2014 is still being counted, although estimation can already be called as very accurate. ECB is almost sure that the European economy has expanded by 0.8% in 2014, and makes forecasts for the upcoming years. It builds it policy assuming the real GDP growth at 1.0% in 2015 and 1.5% in 2016, which was announced in Account of Monetary Policy Meeting. We should remember that these estimations already include the massive QE and assumption that the appeared difference in interest rates won’t remain solely in MFI (monetary and financial institutions) – the banking sector which we know from macroeconomics lectures as the second column of banking hierarchy, but will transfer its impact to “the society”, which is represented by the third column. If it happens, we are supposed to see the inflation rate above 1.5% in 2016, which is what ECB expects to be the healthiest for European economy by meaning “close to 2%, but not higher”. Frankly, now even the best economists can say how the quantitative easing will be successful in Europe. The forecasts of the public and private sectors are almost equal today, but both of them assume the highest uncertainty for previous years, so today the best decision is to act prudently based on forecasts, in other words – wait and see!