If ever there was a case of “recession fatigue” it was Europe in the summer of 2013. There has been nothing but optimism from the Continent throughout, and sunshine purportedly reflected a burgeoning recovery that was far more broadly situated than the vagaries of Germany’s export economy. Spain and Italy were to be among those that could proudly proclaim, as Bernanke once did in 2008, that the worst was behind. France, it has been suggested, will avoid going the full PIIGS route after all.

To some varying extent, last week’s rate cut by the ECB ran counter to those sunny narratives. As has been the case since 2007, it is perfectly clear that mainstream commentary understands very little of the mechanics of European monetary systems, so it was no surprise that very little insight was provided into the rate decision itself. It’s not just simply case where the ECB is cutting rates to “stimulate”, or even guard against economic retrenchment. That is the American version of central banking and it is not really portable.

The complex ECB/NCB system involves a rate “corridor.” The ECB left the deposit rate, the floor, at 0%, where it has been stuck since the middle of 2012. Instead, the ECB “narrowed” the monetary policy rate corridor for the second time this year. Part of this relates to the unending fragmentation of the liquidity system across the geographic divide. For all the talk of recovery, the monetary system is still very much divided by PIIGS v. Core.

ABOOK Nov 2013 Inflation ECB Interbank

We will know that there is an actual recovery in Europe once Eonia starts “behaving” properly (for a primer in ECB/NCB mechanics, including to what Eonia, MRO/MLF rates pertain, go here). Since the major crisis in late 2011, after all the LTRO’s and monetary distortions, Eonia still shows a liquidity system very much in doubt about prospects for the peripheral financials. In other words, the fact that Eonia continues to trade below its “normal” place attached and around the MRO midpoint shows that financial firms are very much still in the pessimistic camp.

ABOOK Nov 2013 Inflation ECB Corridor

The ECB’s monetary decisions in 2013, then, center on this issue. In both rate movements the central bank has voted to narrow the rate corridor. When the ECB first appealed to corridor width back in May, I wrote,

“The implications of a narrow corridor are essentially liquidity management, not economic stimulation. By reducing the spread between the deposit rate (where Eonia has traded since the crisis) and the MRO, the ECB is essentially acknowledging that interbank lending will not be returning to the periphery any time in the near future. Reducing the MLF rate by 50 bp is a signal that the ECB is seeking to harmonize liquidity rates across the continent. What they have done is offered unlimited liquidity (dependent on collateral) to peripheral banks at interest rates closer to where core banks borrow. That reduces significantly the incentive of core banks to lend to peripheral banks, meaning this measure is not aimed at ‘healing’ the financial liquidity divide.

“But narrowing the corridor does promise a more homogeneous rate environment for banks in varying stages of liquidity distress, making them more likely to take advantage of ECB facilities (again, collateral dependent). That was the intent at the height of the crisis in 2008-09.”

The corridor decision is a monetary decision not aimed at getting the economy moving, per se, but bridging the divide by using its own monetary programs – the ECB is giving up on the interbank market “healing itself.” Rather than getting Deutsche Bank to free up some excess euros currently parked at either the ECB deposit account (yielding 0%) or at other “core” banks (yielding practically 0% at Eonia) in order to lend out to some small Italian bank, the ECB instead intends to reduce the MRO rate at which that small Italian bank can gain overnight euro financing to something closer to Eonia. If you can’t lead the bank horse to water, dig a euro canal to get to the horse (or something as silly).

After wading into this mechanical analysis, the obvious question is why the ECB is extending this kind of monetary program further into distortion. The answer lies in the lack of recovery, despite the very loud (and likely very premature) proclamations that the worst is behind.

Despite trillions of euros, there is no inflation in Europe. Despite a recovery narrative now spanning a half year (or more), there is no inflation in Europe. I should clarify that I mean inflation in the orthodox sense of price changes. According to economic orthodoxy, a healthy or true recovery would show up in rising inflation as businesses increase prices as well as wages (remember, mainstream economics defines inflation in theory as a wage issue). Instead, we have seen the opposite.

ABOOK Nov 2013 Inflation Europe

Inflation rates across Europe, including some core nations, have sunk to levels not seen since the Great Recession – and they are getting worse. The lack of inflation is very much tied to the Eonia/rate dysfunction of which the ECB is trying to address: there is a distinct lack of demand in Europe. That includes the demand for money as well as the demand for goods and services.

In 2013, the idea of recovery has taken a beating as it gets redefined to something more closely resembling stock prices and asset inflation. But a recovery is nothing of the sort – it is precisely rising demand for money that reflects a healthy desire to take on actual (as opposed to purely financial) risk. If that definition is correct, and it is, then what we see in Europe is again nothing more than the monetary illusion rather than actual recovery.

What is even more ominous is that the chart above should be very familiar to American observers. Inflation, or the lack of it, is not just a European “problem.”

ABOOK Nov 2013 Inflation Europe-US

This correlation has very broad implications beyond just monetary insanity. What it speaks about is the lack of demand for money across the globe for anything but financial speculation. The lack of consumer inflation is actually quite straightforward, relating to inventory and excess capacity. This “disinflation” tends to be a result of excess supply or inventory becoming discounted as demand fails to materialize (again and again) at expected levels (too much optimism driven by faith in “stimulative” policy?).

For global trade, with the US and EU being the largest end markets, this lack of demand feeds back into the global supply chain. That means less demand for manufactured goods from China, and thus less demand for raw materials from places like Canada, Australia and most especially Brazil. No amount of monetary reckoning can create end demand directly. Despite popular imagination of “money printing”, central banks know their only hope is in psychology and manipulation. But instead of cajoling businesses to take on actual risk, they simply move incentives toward asset inflation driven by speculation.

Inside this wider context, the ECB’s rate movements fit the wider central bank pattern. There is no such recovery outside of volatility in currencies (which is not the same thing no matter how much orthodox adherents proclaim otherwise), and the closer we get to anchoring inflation expectations far below central bank targets the more panicked they become. Deflation is the worst nightmare of every current central bank policymaker at every central bank in the world. Nothing says deflation more than a lack of demand for money.

 

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