On December 12, the ECB had lowered its three policy rates by 25 basis points each – the most important one, the so-called deposit facility rate, has now reached 3%. Until last summer, and for about one year, it had been at the record level of 4%. The direction is clear: since the euro area economy is very weak while, mostly because for this reason, consumer price inflation is approaching its 2% target value, the ECB has more or less announced that rates will be cut further. By how much?
In the medium term the equilibrium policy rate is in the order of 2 to 3%, which is the product of the growth rate of potential GDP and target inflation. On this basis, the new deposit facility rate is almost there. The question is whether the equilibrium rate is at all relevant in today’s environment. I think it is not!
For several years the labor market of the euro area had been surprisingly resilient in the face of low and declining GDP growth rates, but now overall employment has begun to shrink after all, and leading indicators suggest the euro area economy is heading straight into a recession, despite the stimulus provided by a weak exchange rate. The economy needs a strong, or even a very strong monetary boost because fiscal policies are once again focusing on consolidation, ie, lowering budget deficits, and are of no help when the main issue is to strengthen the demand for goods and services.
Nobody must worry about inflation at this point. Going by the prices for imports and industrial products, which are about the same as one year ago, or the growth rates of lending to the private sector or money supply M3, disinflation is now well under way. Prices for services – where we observe catching-up effects – are still preventing a faster decline of headline inflation for consumers, but this is probably just a temporary phenomenon as the situation on labor markets has finally begun to deteriorate in earnest.
I am so confident about this because there is a large gap between overall demand and potential supply in the euro area. At the beginning of the currency union in January 1999, trend growth of real GDP (a proxy for potential supply) had been estimated to be 2¼%, had then declined to 1.9% in the years before the Great Financial Crisis and has then fallen to just 0.8%. If those 0.8% are in fact the new normal, potential GDP would be fully employed these days, and we would have to worry that inflation rates will rise again. Inflation is mostly a function of an economy’s rate of capacity utilization.
No one knows the true size of the output gap. Provided the old 1.9% trend of 2001 to 2007 were still in force, it would be no less than 17% of potential real GDP today, meaning the economy was heading in large strides toward deflation – which is a situation where business and consumers are reluctant to spend because things would become cheaper over time. It would pay to hold back spending. No spending, no growth.
It is also totally unclear why there has been such a massive structural shock after 2007, and none of the professional forecasters at Germany’s Council of Economic Advisors, the economic think tanks, the ECB, the EU Commission or the OECD had seen it coming, and they are still at a loss of identifying the reasons. They only largely agree that the new GDP trend is about 1%. Was it the overwhelming competition from China, the rapid transition from a fossil fuel-driven to a green economy (including e-mobility), too many stranded assets, high gas prices, or a saturation of demand which could be expected in rich countries at some point? The output gap is probably neither 17% nor zero, but somewhere in between – but it is certainly not small. Its size will prevent inflation becoming a problem again – excluding new price shocks from wars or trade disruptions.
For 2025 the forecasts of the above-mentioned institutions for euro area real GDP are between 0.9 and 1.3% y/y. In the following year, in 2026, growth rates are expected to be just 0.2 to 0.3 percentage points higher. The US economy, meanwhile, continues to power ahead at rates of almost 3%, and the Fed has suggested that there will be only two more cuts of 25 basis points in 2025 (according to its dot plot graph). In such a scenario, it pays to borrow in euro and invest in dollar assets (the so-called carry trade) – the effects of such a strategy on the euro exchange rate are obvious.
European policy rates must be quickly reduced to a level where it does not pay to wait for falling consumer prices. Investments in hardware and software are not as much stimulated by low interest rates as by a consensus that they will not fall much further.
If it is 2008 all over again, European policy rates may well fall by another 350 basis points. This would be good news for long term interest rates (bond yields), European stock markets and probably for growth and employment. I wonder how the ECB is looking at things. We may need more bad data from the economy before monetary policies are loosened more aggressively.
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About Wermuth Asset Management
Wermuth Asset Management (WAM) is a Family Office which also acts as a BAFIN-regulated investment consultant.
The company specializes in climate impact investments across all asset classes, with a focus on EU “exponential organizations” as defined by Singularity University, i.e., companies which solve a major problem of humanity profitably and can grow exponentially. Through private equity, listed assets, infrastructure and real assets, the company invests through its own funds and third-party funds. WAM adheres to the UN Principles of Responsible Investing (UNPRI) and UN Compact and is a member of the Institutional Investor Group on Climate Change (IIGCC), the Global Impact Investing Network (GIIN) and the Divest-Invest Movement.
Jochen Wermuth founded WAM in 1999. He is a German climate impact investor who served on the steering committee of “Europeans for Divest Invest”. As of June 2017, he is also a member of the investment strategy committee for the EUR 24 billion German Sovereign Wealth Fund (KENFO).
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