At first, they really thought the price pressures would be transitory. After some reconsideration, they changed their collective minds. Oil markets were rampaging, seemingly nothing to stop them, creating “inflation” headwinds that couldn’t be so easily discounted. Politicians were breathing down their necks demanding policymakers work out some relief. Those at Europe’s “central bank” knew of only one method.
Rate hikes.
In July, in announcing them administrators admitted to the “mistakes.” The ECB’s top official began the prepared remarks with the requisite mea culpa:
“This decision was taken to prevent broadly based second-round effects and to counteract the increasing upside risks to price stability over the medium term. HICP inflation rates have continued to rise significantly since the autumn of last year. They are expected to remain well above the level consistent with price stability for a more protracted period than previously thought.”
Not July 2022, though you’d be forgiven for thinking so. No, this was July 2008. Yes, 2008. The mid-point of a global Great “Recession” by then seven-plus months into its dirty business.
On the one hand, even today you can understand though not condone why officials changed their mind. It all began with Brent, meaning crude. It’s always oil over everything, no matter how many times it comes back to haunt us after burning them.
The previous autumn, 2007, the price for benchmark (for Europe) Brent sweet crude had been relatively tame under €60 per barrel. While the “subprime mortgage crisis” was breaking out in America, even somehow engulfing small parts of England (Northern Rock), by and large there appeared to be little for Europeans as a whole to be concerned about.
Unsecured money rates were only slightly disturbed in the wake of the chaotic events from August 9, 2007. There had been an initial 16 bps spike to Eonia, the unsecured overnight interbank rate for euros, but even that wasn’t entirely unusual given how the ECB had been steadily raising its benchmark corridor rates (MLF, MRO, Deposit Account) for over a year.
After some heavier and more uncomfortable volatility in early September, Eonia settled down – kind of. Rather than trade on top of the MRO midpoint, as it had and should, the overnight rate often went below and kept doing this into January 2008.
From that time until early July, however, the discrepancy diminished and often disappeared for stretches (meaning Eonia back at least equal with the MRO) making it appear as if whatever hiccups in European money the prior autumn were handled appropriately by someone.
As that was going on, Brent was on the move. Thus, it was easy to forget about Eonia and trying to make sense of its odd behavior, placing sole focus – and being made to focus by political mastership – on the direct, increasingly huge oil effect on various consumer price buckets.
In fact, crude would rise to over €90 per barrel by the end of June 2008, surprising the ECB’s staff models and leading to the apologies expressed by then-President Jean Claude Trichet quoted above. According to those model projections, the balance of risks had decidedly tilted toward inflation, nary a contrary deflationary risk detected by what you would assume had been the close watch of technically proficient monetary authorities.
Even Germany’s spooked bond market had backed down, a touch, from more extreme positions early in 2008 reaching their climax on March 17 – Bear Stearns.
Like Eonia, shorter-term German yields would dip below the MRO, then set to 4%, at times after October 2007 to an unnerving degree. By January 2008, just as Eonia was seemingly normalizing, bund, bobl, and schätz rates all fell sharply below the policy midpoint before then retracing the entire deficit by June.
As in America, those officials in Europe had believed they dodged any real collateral damage from whatever bullet everyone thought had been fired at the Fed. Bear Stearns came to be seen as the point of maximum danger, and the world had escaped with minimal even undetectable damage due to Ben Bernanke’s reportedly skillful exercise.
Trichet even said so in July 2008, reciting this belief as justification for the ECB to go after oil:
“Moreover, continued very vigorous money and credit growth and the absence thus far of significant constraints on bank loan supply in a context of ongoing financial market tensions confirm our assessment of upside risks to price stability over the medium term. At the same time, while the latest data confirm the expected weakening of real GDP growth in mid-2008 after exceptionally strong growth in the first quarter, the economic fundamentals of the euro area are sound.”
None of that was true, as the world found out in a matter of weeks. What had “monetary” authorities missed, and why so badly?
For one, they incorrectly surmised low Eonia had been a weird but overall positive development. Just as the Fed dismissed low fed funds as “too much” money, European officials also reasoned below-benchmark effective rates were a sign of systemic cash surpluses.
They were not, not even close, in either denomination.
In Europe, as unsecured markets fell into increasing – not decreasing – disorder destructive mistrust, participants stopped lending to each other in favor of just leaving cash on deposit with the ECB. For whomever was left in unsecured markets, this selection bias favored only the best (perceived) borrowers, which meant intermittent downward pressure on the effective Eonia (like fed funds) rate.
Any truly comprehensive effective rate would have instead considered the growing list of funding participants who found they couldn’t borrow euros (like dollars in fed funds, or eurodollars, meaning LIBOR) at any cost – an effectively infinite rate for much of the marketplace that doesn’t add in to rate calculations made from only the transactions actually done (off topic, the very argument why LIBOR is actually superior).
In other words, the persistence of low Eonia even if not every single day was something which should have alarmed those at the ECB. This was a breaking down of funding fundamentals increasingly at the expense of a wider circle of participants beyond those initially directly afflicted. Spreading contagion.
As those multitudes were shut out from unsecured possibilities, they went looking for the only other option, secured. But this had meant securing first the securities necessary to be able to then secure continued balance sheet liquidity and funding.
Then another factor no one at the ECB (or Fed) considered, the fast-shrinking list of acceptable collateral.
In Europe, that meant funneling the enlarged herd of euro-seeking borrowers toward government bonds, especially those issued by first-rate (liquidity-wise) Germany’s federal government. Eonia from January to March 2008 seemed placid though a touch low because of how many exited that unsecured market for the last resort of bund, bobl, and particularly schätz-held repo.
The prices for those surged, a heavy liquidity premium actively being paid by the whole marketplace all the while central bankers were convinced of the opposite. Therefore, yields fell substantially below the ECB’s hapless, largely irrelevant MRO policy target. By March 17, the Monday of the Bear announcement, the 2-year German yield was just 3.12%, the 5-year 3.24%, the MRO still 4.00%.
Monday, July 3, 2008, had been the day when the ECB announced its inflation-switch, the 25-bps rate hike which moved the MRO up to 4.25%. It also marked the absolute peak for German bond yields, a top which stands to this very day.
After retracing from the Bear low in March, bond rates had actually renewed their downward slide by mid-June, only temporarily detoured by Trichet’s huge gamble. The very next day, July 4, yields absolutely collapsed; the 2-year from 4.77% to 4.50%. By the 16th, down to 4.35% before trading back below the MRO by August 8.
The market wasn’t looking at this one single July rate hike being the inflation- even economy-killer sold to the public, collateral demand in Europe as eurodollar (and euroeuro) had been rising already for a month by then indicating renewed disruption, distress, and deflation.
When the ECB said inflation was the biggest risk in July 2008, that claim was based on oil prices and unemployment rates not actual monetary conditions, a massive, unforgivable mistake.
A mistake they would egregiously commit yet again not even three years later.
On April 7, 2011, the ECB under Trichet again switched up its policy stance, convinced one more time that inflation was the primary risk facing Europe (and the world). The ECB’s President said this 25-bps rate hike was, “warranted in the light of upside risks to price stability” as if he had been asleep since July 2008 and had simply read from his prior prepared script.
By this point, Eonia was mostly irrelevant, pegged almost entirely well below the MRO, stuck closer to the Deposit “floor” given how unsecured markets had almost entirely disappeared, or at the very least the riskiest borrowers – too many to count – had been disappeared from them during the previous deflationary debacle. With only the best credits borrowing, they could borrow at the lowest costs, merely proving what Eonia had been indicating during the prior crisis.
German bund yields from late 2010 had been rising in what may have been a comforting fact for policymakers, assuming they paid any real attention to them at all. However, almost exactly like 2008, those bond rates would peak the day before the April 2011 rate hike became effective.
From that point forward, trouble was clearly brewing, a point emphatically made three months later in July (what is it with the ECB and July?) when, ignoring everything else, Trichet raised the ECB benchmarks for a second time by another 25 bps. Outside of one week’s worth of retracing, the whole German and European bond markets largely ignored them.
In both these cases, 2011 as 2008, severe recession followed as the natural consequence of this dreaded monetary disease, a pair of them stuck so close together Europe has never come close to recovering (especially the more collateral-starved Southern “periphery”).
Having heard the news this week, you already know where all this is going. Once more here we are in July, therefore the ECB’s time to do what it does best – start hiking rates into the beginning of, if not already-underway, deflationary recession. Different leader, different decade, same thinking.
What is different this time is Christine Lagarde’s commitment, and how much more oil-over-everything has gripped the ECB’s models. Yesterday, the “central bank” raised its three benchmarks (still MLF, MRO, and Deposit floor) by 50 bps each, a double shot that…was promptly ignored in German bond trading.
Rates there had been rising since last December in anticipation, just as they had been in Spring 2008 like Late Winter 2011. But then, consistent pattern, bund, bobl, and schätz rates topped out in the middle of last month.
A European rate hike is the global economy’s Kiss of Death, the ultimate in contrarian indicators. No one ever rings a bell at the top, they say, but whomever is on top of the European Central Bank at any time apparently possesses the uncanny ability to provide a similar enough service.
Fearing always oil, looking steadfastly in that one direction, none of them are able to see the deflation freight train steadily building up speed directly behind them. This can feel like déjà vu, but it’s much simpler than all that. Just criminally corrupt incompetence. Again.
According to the European Commission’s survey, July 2022 consumer confidence across Europe has never been lower. Not 2020, nor 2012. Not even 2009. Maybe the average European is just tired of the repeated (global) fallout they can see coming.
