"Sustained Convergence": The Most Important Words from Frankfurt for 2016

October 31 2016

The ECB-meeting last Thursday was all but exciting, perhaps even flat out boring. That is more or less the sentiment of most pundits about the ECB-meeting of last week. In my opinion, this prevailing sentiment does no justice to the meeting. And I argue that this is the case because of just two words, which were mentioned in the press release that was published after the, indeed, deadly boring meeting.

After the past few meetings, the ECB repeatedly mentioned that the central bank would not tighten its monetary policy as long as inflation remains subdued within the Eurozone. Only when inflation returns to the ECB’s target, which is around 2 percent, the bank will consider tightening monetary policy. That meant that we could expect a different monetary policy, or better put: a less loose one, the very moment consumer prices within the Eurozone would rise to 2 percent or at least the expectation would arise that consumer prices will rise about 2 percent in the near future.

Last Thursday the ECB said however that we could expect a reversal of its monetary course when inflation would show a “sustained convergence” to the earlier mentioned target percentage. Despite the appearance that the ECB is saying the same thing but with different words to avoid repeating every comma from its press release of September 8, this is not the case. “Sustained convergence” is something entirely different from “a return to 2 percent.”

QE-tapering

The latter implies that an increase in inflation toward 2% (which is close, mostly because of recovering oil prices as I have described in detail recently) would mean a so-called “tapering” or even an end to quantitative easing (the ECB´s purchase program which amounts to $80 billion euro a month in purchases of both sovereign and corporate debt). The two words “sustained convergence” suddenly become of great importance, because it means that even the fact that inflation exceeds 2% would not suffice to begin “tapering” if and when the ECB judges that the rise in inflation is a result of a one-time event, in other words, that it is “not convergent.” Ever since last Thursday, even if inflation increases to 2 percent the next few months, which as I said before is highly likely, the ECB has an excuse to leave its policy unaltered. Quite a change it seems to me. And, moreover, something that made the meeting of last Thursday everything except boring.

My worst fears are confirmed by the fact that the ECB, whenever inflation starts rising, will downplay and belittle that rise ad nauseam. In a previous article, I wrote that I would not be surprised if, as soon as the downward pressure of falling oil prices on inflation begins wavering in the months and quarters ahead of us and that inflation, as a result, would return pretty rapidly toward 2 percent while economic growth remains subdued, the ECB would start arguing that this rise in inflation is temporary, that it won´t persist, that it is caused by a one-time event; in short, that it will say anything to avoid tightening monetary policy was exactly what I concluded a few months ago. The two words that were uttered by Draghi in last week´s meeting imply, according to my judgment, that my worst fears have just been confirmed.

On a side note, Draghi also said that the ECB-board has not yet talked about slowly tapering quantitative easing in March 2017. This rumor made the rounds the past few weeks in financial markets. This rumor in combination with Draghi´s remark that an abrupt end to QE is not very likely, the consequences of a rate hike (what would be de facto the result if the ECB would end QE) for Eurozone governments, the fact that the global economy remains weak and the forecasts are not very rosy, leads me to conclude that it is very certain that the ECB´s purchases of government and corporate bonds will most definitely not end in March 2017, as the ECB announced earlier. These massive ECB-purchases will continue in 2017 and perhaps even into 2018. And as long as that is the case, ECB-rates have only one way to go: certainly not up.

The Ark of Noah

If I combine all this with my expectations about future Fed-policy (in summary: a rate hike in December and yet again almost no rate hikes in the course of 2017), then inflationary pressures will keep building under the surface and inflation tensions will begin to strengthen. When the inflation volcano finally explodes … it will be very difficult to find a safe haven, but above all it will be extremely expensive. It doesn´t seem like a bad idea to anticipate these troubles ahead. Don´t forget: Noah did not build his ark the moment it began raining, but years earlier.

The above implies that the meeting of the ECB-board in December will be all but boring. The central bank will publish its most recent growth estimates by its in-house economists for 2017, 2018 and 2019; the probability is high that those estimates will differ from the ECB’s previous estimates, which were published in September. That and the fact that financial markets will want to hear from the ECB about what the future of its QE-program is since by then March will be just three months away, might result in a definitive decision by the ECB to continue QE with a high probability that the central banks will even decide to increase the amount of monthly purchases.

Before wrapping up, there is another curious fact about that next ECB-meeting in December. In 1992 it became clear that the euro would replace some national currencies by 1999 at the latest. Most certainly, the guilder would be one of those currencies that would have to make room for the euro.

Almost simultaneously with the decision that some European countries would introduce the euro, the Dutch central bank (DNB) began a powerful PR-offensive. The fact that the euro would mean the end of the guilder was all but a disadvantage for DNB, according to the central bank itself. Indeed, ever since the 80’s DNB had almost no say in Dutch monetary policy. By pegging the guilder to the German mark, the Netherlands already handed over its monetary sovereignty to Germany. DNB had no other option than to follow every interest rate decision of the Bundesbank.

No Voting Rights

With the disappearance of the guilder and the introduction of the euro, the Netherlands would regain a small fraction of its monetary sovereignty, DNB reasoned. Despite the fact that interest rates would still be determined in Germany – both the Bundesbank and the ECB are based in Frankfurt – the president of DNB would be member of the ECB-board and thus have a say in any interest rate decision. If the new monetary commander in chief takes a decision that affects the Netherlands, the Netherlands will be at least at the table. This was never the case when the Bundesbank held the monetary reins: the board of the Bundesbank consisted only of Germans. For the first time in a very long time, interest rates in the Netherlands would be set, among other ECB-members, by DNB. Therefore, the main argument of DNB was that with the introduction of the euro they would gain a greater role in monetary policy than the central bank held in the era of the guilder.

Since the beginning of 2015, ECB’s board members are divided into two groups. Group I consists of the five, in economic terms, largest countries: Germany, France, Italy, Spain and the Netherlands. In the second group we find all the other euro countries. Since last year, the central banks of the different euro countries hold a total of fifteen votes in ECB policy decisions. Group I always holds four of these fifteen votes and the remaining eleven votes are divided among members of Group II.

Who may vote when is established in a rotation schedule. In the case of Group I, the schedule implies that each of the five countries has no voting rights for two to three months every year. This also applies to the Netherlands. For this year, it means that the president of DNB did not have any voting rights within the ECB-board in February and July. According to the rotation schedule, it also means that in December DNB-chairman Klaas Knot will have no say in future ECB-policy. The meeting in December will, however, be very important as I have just mentioned. The monetary sovereignty which the Netherlands regained as a country thanks to the introduction of the euro as DNB argued in the 90’s, is not only in practice a pretense, but even on paper this PR-argument does not apply anymore. When in December the ECB-board will decide in Frankfurt upon its monetary policy for 2017 and beyond, DNB-chairman Klaas Knot will be present at the vote, but I repeat, he is not allowed to actually vote.

Therefore, the Netherlands is back to where it started, which in a monetary-historical sense is the ordinary state of affairs for our country, that is, that we have nothing to say about our interest rates. And I did not even mention another historical development that affected the Netherlands and that is not limited to mere DNB voting rights. I did not mention this development here, but I do in my latest book: ‘Boeiend en geboeid: een monetaire geschiedenis van Nederland sinds 1814/1816’.

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