The ECB, the Euro and what’s being taken on trust

Whilst there’s growing acceptance that we may see co-ordinated quantitative easing (QE) this year, it’s noteworthy that the ECB continues to operate a monetary-based model of inflation that is based on lagged M3 growth. As to whether M3 is really a useful indicator in a changed financial world is a moot point but what’s interesting is that with the ECB, over- and under-shoots from previous years are carried over into subsequent years, whereas in the UK, for example, the clock is essentially reset at the end of each year and any previous target misses ignored. Thus, in its simplest form, the ECB suggests that real M3 growth since the start of the Euro should have averaged 4% per annum, but since money growth in the first half of the 2000s and mid 2000s was significantly higher than this rate, there is still assumed to be a monetary overhang of between 5 and 15% in the system today that one day could translate into higher inflation if the ECB is not careful. Hence, almost uniquely, the ECB still has a hawkish bias and the ECB is apparently wary of the risk that inflation may emerge in a few years’ time if policy is overly loose.

The ECB stance implicitly assumes that when the Euro was introduced, they had the ‘right’ amount of money in the system, when in practice 2000-2001 was a period of upheaval, meaning that the start point may well be wrong.  Secondly, the ECB assumes that the demand for money in Euroland is somehow constant despite the effects of the differing relative performances of the member countries, all of whom have different money demand functions. For example, Germans on average hold much more ‘money’ relative to their incomes than do the Dutch, and so on. Hence any change in the relative sizes of the Euroland member states will result in a change in the overall equilibrium level of demand for money in the system. In addition, economic shocks affect the demand for money and part from the introduction of the Euro itself, we have lived through the global financial crisis and the ensuing Euro crisis, along with material change in the size and composition of the ECB’s balance sheet. In fact, given the conditions experienced over the last ten to fifteen years, it would have been markedly odd for the demand for money to have been stable, although this is in effect what the ECB assume should be the case.

Leaving aside the unusual approach to money, as to whether the ECB is right to worry about inflation at present is of course a moot point, but given the current negative output gaps, weak income and credit trends within the core, and depressions within the periphery, it does not seem likely that a substantial acceleration of inflation is a significant risk at present. However, there are real risks for the Euro in that if the core countries in Euroland shift focus from those who have issued the liabilities (i.e. the creditors in the TARGET2 system such as Germany and Luxembourg who have been obliged to fund their massive lending to the ECB system by creating an equally massive increase in their own reserve money liabilities in their economies) to the assets that the ECB now predominantly owns (i.e. securities and other claims issued by the periphery) and which the core countries’ issuance of liabilities has funded, then there could be a precipitous drop in the demand for Euros.

This may sound complex, but put simply, German savers may come to realise that their Euros are now materially backed by peripheral region ‘junk bonds’ and may opt to reduce their holdings of this compromised currency. Such a drop in the demand for money would then imply that there was an excess supply of Euros, leading to a sharp depreciation of the Euro and a rise in domestic inflation.

In the near term, we may suspect that with the assumptions that growth is recovering and the Euro crisis has passed, the ECB will probably continue to exhibit a hawkish bias, with the Euro remaining firm, despite the adverse implications for the region’s economy. However, if it becomes apparent that global recovery is not on course, and the crisis in the periphery re-emerges, then the ECB may be viewed as having been overly hawkish with resurfacing concerns on the viability of the Euro. As for when these risks may emerge, the end of the second quarter looks pretty key, as by then we will have adequate data on the progress of the world economy and Asia in particular, in absolute terms and relative to expectations.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla