Followers of monetary policy will know that the recent expansion of the money supply in the Eurozone and elsewhere is unprecedented. To deal with the economic consequences of the Covid-19 pandemic the European Central Bank (ECB) has kept interest rates at historically low levels to encourage borrowing. What is more, the ECB has embarked on the Pandemic Emergency Purchasing Programme (PEPP). In this programme the ECB is purchasing both government and corporate bonds to facilitate borrowing by these institutions. The big idea is that cheaper borrowing will lead to more expenditure that the economy needs to grow.
The danger of monetary expansion of course is that with more euros in circulation every euro will become less valuable. This process has been going on for many years and has for a long while been hidden behind smokescreens. The cost of rent and house prices for instance are not taken fully into account even though these are the largest expense item for most citizens. Inflation can however impossibly be further ignored with the obvious price increase of many consumer goods. The textbook solution here would be to raise interest rates or at least to scale back the PEPP to stop the economy from overheating.
Sadly this option is particularly unattractive for the ECB. Its president, Christine Lagarde has to be mindful of the fact that many European governments carry a heavy debt load that could quickly become unsustainable if interest rates rise. Possibly the most important leader Lagarde has to deal with in this regard is her predecessor, Mario Draghi, currently the prime minister of Italy. On the other hand the Eurozone countries with a more manageable debt are understandably more concerned about inflation. Dutch central bank president Klaas Knot has been the most vocal proponent of stepping on the monetary brakes. Lagarde has to navigate between Scylla and Charybdis, or more bluntly, between a rock and a hard place. In a biblical reference those in favor of monetary expansion are called doves while those who favor a reversal of monetary expansion are known as hawks.
Whatever course Lagarde decides on she has to be ensured of the support of one key constituency: financial markets. Because stocks generally rise with inflation and corporations benefit from soft lending conditions the market is generally in favor of monetary expansion. Any unexpected move by the ECB could spook investors. This could lead to a market crash with serious consequences.
Although central banking is often framed as apolitical and technocratic it does have serious political ramifications. Although dovish policy increases the value of stocks and real estate it does not directly increase the value of wages. At the same time, low interest rates have a detrimental impact on pension funds that rely on interest rates to pay the pensioners. Lower interest rates necessitate either a cut in income for current pensioners or an increased risk for those who will need a pension in the future. Dovish policy makes the poor poorer while it makes the rich richer. While national governments are closely watched by the press and face opposition for every small reduction in citizen living standards the impact of ECB policy is much greater. It can print as many euros as it wants, apparently with little scrutiny. Fire of Europe is determined to contribute to rectifying this lack of oversight.
Although I have been very critical of the ECB in the past I also want to compliment them when they do things right. During last Thursday’s press conference Lagarde succeeded in taking a subtly hawkish stance without spooking the markets. Although interest rates are maintained at the same level Lagarde indicated that PEPP will continue at a decelerated speed and will possibly not use the entire allocated 1.850 billion euros. Although it is a very small step in the right direction it is a good development, especially since the ECB managed to take it while at the same time pleasing investors.