Central Bankers, Like Auto Mechanics, Enjoy Endless Information Asymetry
People are often wary of getting their car fixed because they know so little about them. Sure, we know how to drive our vehicles and fill their tanks with the appropriate fuel. Other than that, it’s a big mystery. You turn the key and the machine just comes to life, ready for whatever simple inputs may be required for its operation.
Should you ever attempt to start the engine and it fails, or should it begin making ominously repeating noises, what to do then?
The auto mechanic is a professional who has gained and holds tremendous information asymmetry. How many hours of sitcom or movie comedy have been devoted through the years to the clueless car owner uneasily nodding along as they are told about the absolutely necessary, and expensive, repairs to their spark tubes and timing needles? There’s truth underlying the jokes.
We may not know much about engines and transmissions, but after enough time we can figure out when we are being ripped off. You don’t stick with a mechanic who has to fix the same problem over and over; easily concluding that, though you don’t really know what’s wrong, you can be absolutely sure your mechanic doesn’t, either.
And what would you do with one who tells you not only does your vehicle need to be repaired, it is going to need to be repaired constantly? You’d probably be mad enough to file a complaint with someone somewhere.
The analogy is far from perfect. It is, however, close enough in this context.
At its latest policy meeting, the European Central Bank’s Governing Council has played the stereotypical role of unscrupulous mechanic yet again. One year ago, its chief technician, Mario Draghi loudly and consistently proclaimed the European economy had been fixed. QE, still ongoing after three years, was finally going to be ended and what was going to follow in 2019 would be a liftoff – rate hikes and some semblance of normality.
Hemming and hawing over how expensive the bill was for the repairs, Europeans paid it anyway at least relieved their economic vehicle had been overhauled, as they had been led to believe, and was finally ready to get back out on the highway.
Yesterday, however, the ECB has experienced a change of heart. The Governing Council’s statement “also underlined the need for a highly accommodative stance of monetary policy for a prolonged period of time.” This is where the analogy fits best; if something “needs” to be repaired for a prolonged period of time the person or group conducting the repairs really doesn’t know what’s wrong or how to fix it.
Not so, says the monetary mechanic. The counterpoint is the status of the vehicle undergoing examination. You may see a fine and workable economic automobile with low mileage and little wear. But to top mechanic Draghi, what you’ve brought to him is an old, dilapidated piece of junk held together by duct tape and chewing gum.
Of course it needs constant maintenance.
This is the essence of the argument, the pseudo-intellectual foundation of what’s called R* (or R-star). Is Europe’s economy broken to the point where it just falls apart without constant intervention, or is the intervention basically smoke and mirrors to keep the customer happy and coming back?
That’s why central bankers were setting themselves up for nothing good in 2017. They went “all in” on globally synchronized growth based on emotion. It hasn’t just been the European economy plagued by low growth, or low R*, this is “somehow” a global problem. US officials in their recent “dovish” turn have been in overdrive selling R* as the reason.
Globally synchronized growth would have been the sign of a successful conclusion. In other words, when things picked up modestly in 2017 officials all over the globe seized upon the idea that their policies were being vindicated – the world’s economy was NOT beyond repair. In fact, they had done it!
The widespread celebrations of 2018 were along those very lines. Starting in Japan with Haruhiko Kuroda’s open and obvious giddiness publicly predicting that QQE would be ended by the start of the next fiscal year. Jay Powell’s bull-in-a-china-shop hawkishness right from the get-go. And Mario Draghi dreaming about how his 2019 retirement was the perfect Hollywood ending, where he would ride off into the sunset with rate hikes, inflationary pressures, and the sustainable recovery which would etch his name on the tablet of central banker fame.
It wasn’t just premature; it was a categorical error. And one that in 2019 is being further exposed. They can’t just decide one year they’d finally unlocked the right combination of policies to have done the trick after a decade of trying, and then the very next year throwing up their hands and proclaiming the economy is still broken.
All they’ve done is demonstrate, prove that they don’t really know which is which.
That is why the puppet show is being re-rehearsed as we speak, getting prepared for curtain-up all over the world in the coming months. In several places, the show is already started its run. From New Zealand to Australia (twice) to South Korea, the “stimulus” and “accommodation” has made its off-Broadway re-appearance on stage.
A more realistic analogy of the global situation is thus: you’ve brought your car to the shop but one where the auto mechanic is really just an actor who specializes in playing the role of an auto mechanic. You can even observe the performance; it really does look like there is something going on back there with your car’s hood propped open, the engine exposed, and the “mechanic” making obvious, convincing motions with his head, hands, and arms.
But he doesn’t know one thing about cars and engines; all he was taught in performing arts was how to make obvious, convincing motions with his head, hands, and arms.
He’s as in the dark about what’s wrong with the machine as you are. And the constant need for repairs proves it.
There is a class of vehicle owners who have not been fooled: the bond market. Bond yields especially in Europe never bought globally synchronized growth, not really. Interest rates backed up a little in 2017 and early 2018, but it was minor and way, way less than the hype surrounding the project.
That’s why in early 2019 yields so quickly reached new record lows; they didn’t have very far to go.
With that gut punch hitting just before retirement, Mario Draghi now has to take another one right in the face. European money markets are joining the bond markets in revolt; though, again, there wasn’t that much distance to travel.
While in 2018 the ECB Governing Council was projecting an end to QE and then rate hikes shortly thereafter (having learned nothing from the Fed’s 2015-16 experience with the same difficulties), euro money markets were likewise unenthused. Only the 12-month Euribor rate (unsecured interbank lending of euros for a term of one year) would move up during 2018, and it wasn’t much.
It stood in contrast to the last time recovery was declared (because this really is just a repeating process, and the puppet show’s premise requires you to suspend your disbelief by forgetting this has all happened before) in 2013. Back then, banks to a higher degree believed it could have been possible. They repaid LTRO balances (the QE before QE) by the hundreds of billions, and euro interbank rates rose from top to bottom.
Last year, money markets just kind of shrugged and said, whatever Draghi.
The matter is much more serious, though, especially in mechanical terms. Negative Interest Rate Policy (NIRP) is another one of those “highly accommodative” stimulus plans that everyone keeps calling it that because everyone keeps calling it that. What it really amounts to is a penalty on liquidity - that’s the whole point.
The ECB like the Fed has created bank reserves. It believes that by creating all these bank reserves this is why money market rates are low, an over-abundance of them. That’s not all policymakers wanted to see when they decided to create them. They had envisioned banks would thank them for the liquidity and because liquidity was so plentiful they’d go back to being banks – extending credit by the bushel leading to inflation and the virtuous economic circle of recoveries.
Instead, banks tended to just hoard the liquidity and park it wherever and in whatever vehicle they could. Puzzled by the outcome, Europe’s monetary Governing Council in 2014 decided the banking system needed some negative reinforcement to go along with even more abundant “liquidity.”
A negative interest rate penalizes banks for holding reserves, prodding them to be more productive (from the ECB’s standpoint). Throughout 2015 and 2016, European banks quite naturally (from a standpoint of reality) refused the invitation and paid the penalty. The ECB increased the tax (twice) to make it more painful, eventually lowering the Deposit Rate “floor” to as much as -40 bps.
That’s where it still sits today, the ECB never having had the opportunity to reverse it.
Now comes more QE on the horizon (as I’ve said, if you have to do quantitative easing more than once it cannot have been quantitative and already proposes serious questions about the easing part). As part of “the need for a highly accommodative stance of monetary policy for a prolonged period of time” there’s almost certainly going to be even a program restart in Europe. Most likely beginning the next time the Governing Council meets in September.
European banks have howled in protest. We already know because Euribor rates have plummeted.
Twelve-month Euribor had been up above +30 bps back in late 2014. It steadily declined throughout QE so that by January 2018 it was trading at around -18 bps. One-week Euribor, the shortest tenor (the overnight rate is Eonia; don’t ask), went from around zero late in 2014 to pretty quickly reaching near the -40 bps “floor” in the summer of 2016.
That’s why longer-dated Euribor maturities kept falling throughout 2017 despite globally synchronized growth. Once a specific maturity of Euribor fell near enough (a few bps) to the Deposit Rate, banks would dump more reserves in the next one up. They all started to converge well below zero, the banking system paying the penalty on “liquidity” from one end to the other.
From January 2018 to around February 2019, 12-month Euribor rose – which is to say it retraced all of about 8 bps, making its high point earlier this year all of -11 bps. One-week Euribor maybe budged here or there by one or two bps.
Beginning around May, however, euro rates plunged even though at that time the ECB was still relatively optimistic (it wouldn’t signal the “need” for more “stimulus” until the middle of June). Twelve-month Euribor, as of yesterday, was -31.1 bps; well below its previous record. One-week Euribor was, brace yourself, -40.5 bps.
Both the one- and two-week (-40.7 bps) maturities are currently below the floor. Or, I should write, “floor.”
If QE is to begin in September, there’s no current basis for these shortest of terms to puncture the Deposit Rate like they have. Even 12-month Euribor (a real plunge) doesn’t seem consistent with a slow build up of reserves under the next QE. Something changed in early May inside the euro money markets.
What that means is banks have been increasingly willing to pay higher and higher penalties for hoarding liquidity at longer and longer terms. If that sounds like stimulus to anyone it’s because those particular people are avid theatergoers.
In response to repeated complaints, the ECB announced yesterday that when it does get to its QE3 (the original QE1 was expanded in March 2016) there will probably be some “tiering” involved. A tiered structure aims to reduce future penalty rates for additional “liquidity” added by renewed central bank balance sheet expansion.
Apparently, in the minds of policymakers, banks are being penalized more than sufficiently right now. So, what the hell was the point of NIRP?
Our crafty play-actor motioning wildly over top of your car engine wasn’t really holding a wrench or socket – but a lot of people were convinced it was, that it had to have been a useful tool based on nothing more than their love of performance.
Drama critics, especially, are always enthralled when they bring their automobiles in. The financial media cannot get enough of this stuff. Here’s a Reuters article from the middle of December 2018, while bond yields were falling all over the world including and especially Europe:
“An era of extraordinarily easy monetary policy in the euro zone is drawing to a close as the European Central Bank is set to announce formally on Thursday that its massive bond-buying scheme will be terminated at the end of this year.”
The puppet show’s performance was further lauded, the article gushing, “As intended, QE has lifted economic growth while wages and lending have risen.” And yet, somehow within six months authorities were already thinking about diving back in with more “extraordinarily easy monetary policy.”
I suspect most people under these circumstances prefer Euclidean geometry to weak, pandering theater. If stimulus is added and the thing it is added to is not stimulated, the stuff being added is not stimulus.
Under these terms, we don’t have to wonder why banks are so eager to hoard liquidity and pay a painful tax while they do. Nor why, ominously, they’ve decided to substantially add to their hoard, tax or not, more recently.
There’s also no puzzle about the economy, either. It really is a decent enough car which had otherwise suffered a major breakdown about twelve years ago. If only the one auto shop in town wasn’t staffed by actors. The only thing new that we’ve learned about them over the years is that they were all understudies in Japan.