ECB: Negative Interest Rates, QE and Draghi

 

 

Draghi’s negative interest rate intention in 2014 encompassed two original goals. The first was to force money away from bank accounts and sit idle. The second goal was to pressure money into investments by house purchases, real estate, equities. company formation. How is Draghi doing after 3 years of negative rates and what are the prospects.

Wages in July reported 1.6% and higher than 1.4% in June 2016 yet below 1.8% in January 2017. In June to September 2014 when the ECB went negative, Wages were on the floor at 1.4%. Since 2008, Wages went negative. A rise from 1.4% to 1.8 % for context means a $10.00 per hour worker earned $10.14 and rose to $10.18.

European Wages since 2008 saw their best days at 2.5% in 2015 and 2016 when Core Inflation hovered at 0.8 to 1.0%. Wage earners win when Wages trade above CPI as CPI is a price indicator and answers can Wage earners afford goods, food and essentials.

Core CPI prices at 102.06 trades just below first ever highs at 102.47. CPI reported last at 101.71. The 2% target at Core’s 102.06 translates to 2.0412 and 2.0342 for CPI. In 2008, Core CPI was 90.0 and 98.0 in 2014 when the ECB went negative. Took 6 years for Core to gain 8 points on the index from 2008 to 2014 and 4 points in 3 years. Core CPI currently trades far above CPI.
Real GDP in 2009 was minus 4%, 2% in 2010 and minus 1% in 2012. From 2011 to 2014, GDP as a percentage traded below USD and JPY. Since 2014 when the ECB went negative, GDP traded between USD and JPY. GDP last reported 0.6, 3.0% for USD and 1.0% for Japan. Europe now trades again below USD and JPY. The big line for GDP to cross is 2%.

 

Contributions to GDP since 2011 include mostly Financial and Insurance, Information and Communications. Next comes Professional, Scientific, Technical, Administrative and Support services.

GDP is far below Gross Fix Capital formations as investments peaked in 2015, the same time when Wages were at 2.5% and CPI at 0.8. Overall, Ireland leads the way in all categories of GDP from investments to low taxes while Greece remains the lowest GDP contributor and Germany remains competitive.

Exports beat Imports from 2009 to 2011, flat lined then skyrocketed in 2013 to current levels. Exports however in June 2017 at 3.9% were lower than + 6.2% in Imports. The Trade Surplus narrowed to 26.6 billion to 28.9. Germany leads the way with a Current Account Surplus and 3 year 2016 average at 8.1 billion.

The European balance sheet is lower than the FED, BOJ, BOE.

The purpose of negative interest rates was to stop the rate of growth on the positive side of the interest rate. As interest rates crossed from positive to negative, longer term interest rates naturally followed lower into negative territory.

A bottom on the zero side is known as minus 0.0 and the top side is located at + 0.0. Negative interest rates from overnight to longer term then created a tiny channel in which to operate. This means the overnight rate has been stuck at tiny ranges because it doesn’t have room to move. The interest rate curve actually flattened.

The current Deposit rate is minus 0.40 and not far from minus 0. The interest rate can’t go below minus 0.0. What minus 0.40 means is European interest rates are at the lowest possible depths. Draghi’s option to lower is almost impossible not only because of the lowest bound but also because a drop sends CHF, SEK, NOK and DKK interest rates directly on the minus 0.0 threshold.

To add QE to the negative scenario ensured by a sledge hammer effect that interest rates would remain at the lowest depths. As bank accounts failed to pay interest, its was natural to believe the path of money must travel into investments and force GDP growth higher. Negative interest rates strengthened Daghi’s hand on the QE front as he was able to operate inside the small corridors and ensure he wouldn’t see interest rates travel higher.

The intended investment money as well as QE went directly into money markets to trade interest rates for purposes to earn yields on monies. Volumes in money markets and interest rates skyrocketed as a result. The further result to negative interest rates and small corridors is Money is Circulation dropped dramatically which means money velocity remained stagnant. The same old yet dwindling supply of money is sloshed around daily to earn yield.

What flattened and what corridors mean is the distance from borrow to lend rates is extremely narrow. Assess what Wage earners receive when money is invested in a money market mutual fund. The overall purpose to go negative was a forced lending policy as the cost of money is cheap but the borrow side lacked ability. Plenty of lenders but few takers.

To understand the money Supply / demand and interest rate relationship see demand and supply curves and the shifts against interest rates and when QE is added or subtracted.

The exchange rate performed as expected in an interest drop scenario, it went lower from 1.37 to 1.03 over 4 interest rate cuts in a 3 year period.

The EUR/USD is now at 1.2000 due because its economic data slightly beat USD as both are in contention for best of the worst data. The Yellen Vs Draghi scenario is how to relieve the pressure on QE, return interest rates to market appropriate levels and bring the economy back to normal. Both are inside a colossal jam but born by their own false strategies.  Further to 1.2000 is Europe’s corridor is bumping against USD interest rate corridor.
Brian Twomey

View Khan for primer on Money Supply, Demand and Interest rates