Europe
The Natural ECB
Oct 03, 2006

Joachim Fels (London)

(Note: The full note including charts is available on Client Link)

Wave goodbye to easy money.   Since 2001 the ECB has underwritten the euro economy and global asset markets with its expansionary monetary stance.  However, with the fifth rate hike of 25bp in ten months virtually pre-announced for the Governing Council’s rendezvous in Paris on October 5, and a sixth likely to follow in December, interest rates will soon reach what we deem to be their natural, or neutral, level.  This shift from a prolonged period of monetary accommodation to a broadly neutral stance could well have profound consequences for the economy, governments and asset markets, which have all come to rely on the lure of low interest rates during the first half of this decade.  Moreover, there is a distinct risk that the ECB pushes rates above the natural level into restrictive territory next year, which could provoke a hard landing for the economy and markets. 

A quick refresher course:  The nat-EUR-al rate of interest.   The neutral rate of interest is a widely used and fairly intuitive concept — it is usually defined as the level of short rates that neither stimulates nor hinders the economy and keeps inflation stable.  However, the problem with the natural rate is that you cannot look it up on your Bloomberg screen — it has to be estimated.  Moreover, it is unlikely to be a constant, but should vary over time along with some structural characteristics of an economy such as productivity growth, population growth and savings behaviour.  Most analysts simply use a long-run average of real short rates, or their guesstimate of potential output growth, as a proxy for the natural rate; these two methods can be misleading in the light of the theoretical considerations above.

Euro natural rate down one percentage point since 1999.   By contrast, the benchmark I prefer to use is based on the Wicksellian concept of a natural rate of interest, which Manoj Pradhan and I estimate using a simple econometric model of the euro area and a statistical technique called the Kalman filter.  We explained the model and the results in detail in an earlier note (J. Fels & M. Pradhan, The Nat-EUR-al Rate of Interest, May 2, 2006), where we found that the natural rate has declined by a full percentage point since the introduction of the euro — probably due in large part to a slowdown in productivity growth, a rising propensity to save for old age, and an accrual of ECB credibility since the start of EMU.  In other words, structural changes in the euro economy together with a rising credibility of monetary policy have lowered the level of the policy rate necessary to keep inflation stable.  Conversely, if productivity were to pick up on a sustained basis, or if the ECB’s credibility was damaged, the natural rate would rise again.

Back to neutral in Paris.   Our point estimate for the inflation-adjusted natural rate back then was 1.3%, which together with an inflation rate of 2.2% translated into a nominal natural rate of 3.5%.  Since then, our point estimate for the real natural rate has ticked up marginally to 1.4%, while inflation has eased to 1.8% this month, implying a nominal neutral level of 3.2%.   Hence our assessment that a 25bp rate hike in Paris would return the ECB’s policy stance back to roughly neutral.  Of course, a renewed acceleration of inflation back above 2% later this year and early next year, which looks likely, would imply that the ECB has to raise rates once or twice again, just to keep the real rate at its natural level.  Note also that this estimate of the neutral rate is subject to considerable uncertainty — other approaches may lead to different results and thus a different assessment of the monetary policy stance.

Easy money lifted all boats …  Judged against our time-varying estimate of the natural rate of interest, ECB policy has been expansionary since 2001.  For no less than five years, easy money has supported the economy, lowering borrowing costs for consumers, financial and non-financial corporations and governments alike.  True, economic growth was weak by historical norms over most of this period of monetary accommodation, and governments hence struggled to keep budget deficits low.  But without the support from monetary policy, the euro economy’s performance and the state of public finances would have been even more dismal.  Low interest rates also helped corporations to clean up their balance sheets after the debt-excesses of the late 1990s and early 2000s. 

… including inflation.    But easy monetary policy also churned credit growth and created a monetary overhang, which helped pump up the prices of real estate and financial assets both within and outside the euro area, and (along with external shocks) contributed to consumer price inflation exceeding the ECB’s 2% ceiling for no less than seven years now.  With inflation above the ceiling for such an extended period of time and the monetary overhang accumulating, it is somewhat puzzling why the ECB, while stressing the importance of keeping inflation below 2% and reining in excessive money growth, kept rates so low for such a long time.  The only explanation, in my view, is that it was the ongoing economic weakness in the euro area over the 2001-2005 period that induced the ECB to keep its foot on the accelerator.  Only when the economy finally overcame that weakness and started to show signs of a robust recovery from about the middle of last year, did the ECB increasingly feel that a gradual withdrawal of accommodation was warranted.  Ten months after the first rate hike in December 2004, monetary neutrality is now within reach. 

Downside risks to growth.   As I see it, there are two important implications of a return to a neutral monetary policy stance.  First, the euro economy will have to prove that it can stand on its own feet without crutches provided by the ECB.  Five years of monetary accommodation may have lulled private households, companies and governments into a false sense of security by providing them with cheap financing and rising asset values.  The removal of excess liquidity, while fully justified given the potential inflation pressures, comes at an especially inopportune time in the economic cycle: the global economy looks set to slow noticeably going into next year, some euro area governments are planning to tighten fiscal policy quite substantially, and the euro has appreciated in the course of this year.  All these factors combined, together with a return to neutral monetary policy, are likely to conspire to push economic growth below the perceived trend rate of 2% during 2007.  Note that our European economists forecast GDP growth of only 1.4% next year, fully one percentage point less than this year.  If so, the euro economy would be back in the sub-par growth environment that became so entrenched in the 2001-2005 period, but this time without the support from extremely low short-term interest rates.

Global liquidity cycle to turn more negative.  The return to monetary neutrality in Europe exactly at a time when other cyclical factors turn negative not only poses major risks to the business cycle, but also to the global liquidity cycle.  I find it significant that the Fed and the ECB, the two major central banks of the world measured by the size of their economies, have stopped or are about to stop pumping excess liquidity into the global financial system.  The Fed ceased to be expansionary early this year when Ben Bernanke took over at the helm of the Fed and kept raising interest rates above our estimate of the natural rate of interest for the US (4.5-4.75% on our measure, see J. Fels & M. Pradhan, In Search of the Natural Rate of Interest, February 10, 2006).  With the Fed’s policy stance restrictive and the ECB soon no longer expansionary, the global liquidity cycle has only one way to go: down.  Recall what happened soon after the Fed moved into the restrictive zone: global financial markets, especially risky assets, wobbled and corrected sharply in May.  A similar shiver may well go through the system once it becomes clear that the next provider of excess liquidity — the ECB — has turned off the tap. 

A natural pause?   With rates soon back at a broadly neutral level, it would be natural for the ECB to pause in order to assess the impact of the liquidity withdrawal on the economy and inflation expectations.  This is in fact what our European economics team expects to happen after a final rate hike to 3.5% in December, a view that I share.  There is a significant risk, however, that the ECB keeps pushing rates above 3.5% next year, for two reasons.  First, the economy is likely to enter 2007 with still considerable momentum if the current business surveys are anything to go by.  Still-strong economic data for the last quarter of 2006, together with the tax-induced jump of inflation back above 2% early next year, might lead the ECB to take out some more insurance against inflation risks.  Second, the ECB may not share our own view of where the natural rate is.  Some council members have hinted that neutrality will be around or above 4% rather than the 3.25-3.5% level that our model produces.  If this is in fact a shared belief in the ECB council (which I doubt, but do not know for sure) then 3.5% is unlikely to be the peak for ECB rates in this cycle. 

Bottom line.  The impending move back to monetary neutrality in Europe may well turn out to have more dire consequences for the economy and global asset markets than generally assumed.  Moreover, there is a risk (though this is not our main scenario) that the ECB keeps pushing rates above 3.5% next year.  With global bonds already overvalued and priced for benign global monetary policy outcomes, and risky assets complacent about the economic outlook, the bear case for both bonds and risky assets is becoming stronger by the day.

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