Historically, economic cycles have been linked to monetary policy and inflation cycles. Now, we believe central banks are condemned to maintain expansionary monetary policies for a long time. However, this is not to aid Europe’s economic health, but to aid the financial markets – whose bond portfolios have been crippled by the long-term low interest rates that have contaminated the region.
Despite being hailed as as panacea for economic health, the European Central Bank’s (ECB) implementation of its Quantitative Easing (QE) programme, introduced at the beginning of this year, is only for the benefit of the financial markets. Indeed, it is because of bond holders – such as institutional investors and banks – that monetary policies will remain expansionary for a very long time, despite the little aid it will provide for Europe’s inflationary issues or its low growth.
A lesson in monetary history
In the past, economic cycles in the US, the UK and Europe were linked to inflation cycles and monetary policy cycles. At the end of economic expansionary periods – such as those in 1978-84, 1989-90, 2000-2001, and 2007- 2008 – labour costs gathered speed and expected inflation increased, which led central banks to increase interest rates. Indeed, the result was a downturn in domestic demand that eliminated inflation and made it possible to reduce interest rates after a quite short period of time – which in turn would jump-start the economy. In short, after some years of economic expansion inflation increases, there is an increase in interest rates. The inflation cycle, therefore, is linked to the economic cycle, which leads to the monetary cycle.
Today, however, we believe these “monetary cycles” have disappeared and will be replaced by monetary policies that will remain expansionary for a long time, contaminated by low interest rates relative to growth and a persistent abundance of liquidity. Both the “disappearance of inflation” and the “new era” of central banking add credence to this theory.
Farewell, inflation
The drastic change in the functioning of labour markets has been impressive over recent years. In the eurozone, the weakness of real wages is explained by the high level of unemployment. Indeed, the region has suffered a considerable loss of bargaining power for wage earners due to de-unionisation, increasing labour market flexibility – driven by an increasingly large proportion of temporary work contracts, without protection – and globalisation. This has meant that, even in periods of growth, there is insufficient momentum to bring back inflation.
Furthermore, global growth and potential growth have fallen below the level that would typically lead to a rise in commodity prices – reinforcing the absence of inflation that results from wage formation. In turn, the large emerging countries’ economies are becoming weaker due to numerous bottlenecks (specifically skilled labour, energy and transport infrastructure, and the weight of industry in the global economy declining), which is reinforcing the fall in commodity prices.
Of course, the new functioning of labour markets and the fact that we are experiencing insufficient global growth, even during expansion phases, has forced central banks to rethink their behaviour.
A new era of central banks
Over recent years, we have seen a shift in the nature of central banks – which have become prisoners to the market’s expectations. Benoît Coeuré, a member of the ECB’s Executive Board, recently said that a more expansionary monetary policy in the eurozone was “a legal and moral obligation” given its mandate. But despite QE being a moral and legal obligation for the eurozone, it will fail to provide the needed panacea to restore economic health in the region.
Indeed, the implementation of expansionary monetary policies only serves to benefit the region’s bondholders. In the past, long-term interest rates were low only periodically, such as during a recession, and so the subsequent rise in long-term interest rates therefore generated limited capital losses for institutional investors. Now, however, long-term interest rates have been at a low for so long that most bond portfolios have been renewed and replaced by very low-coupon bonds.
Now, a rise in interest rates would lead to massive capital losses for the bondholders – a result the central banks cannot accept. As in Japan, central banks must therefore conduct monetary policies that keep long-term interest rates low to avoid a financial crisis unravelling.
Indeed, expansionary monetary policy could prove to be the bête noire of Europe’s economy.
