Monday, September 19, 2011

The Passive Tightening of ECB Policy

I recently argued that the Fed and the ECB were passively tightening monetary policy and thus responsible, in part, for the increasing economic stress in their regions.  Michael T. Darda makes the same argument today for the Eurozone in his note titled "Anatomy of a Deflationary Debt Collapse":
As the ECB fiddles with its forecast, European inflation-indexed bond spreads have plunged to record lows, while eurozone corporate bond spreads continue to hit new highs for the year. Inflation breakeven spreads in the indexed swap market in Europe have tumbled to the lowest level on record (i.e., below both the 2008 and 2010 lows). With corporate bond spreads at new 2011 highs this morning, the European Central Bank can now be blamed for a passive tightening of monetary policy. Why? Central banks are responsible for responding to velocity shocks by adjusting the supply of money to offset changes in the demand for money. If there is a spike in the demand for money and a central bank does nothing, a “passive tightening” of monetary policy will ensue. The message from plunging inflation breakeven rates and surging corporate bond spreads is that the eurozone could now be headed for a negative velocity shock and thus a deflationary debt collapse. There will simply be no way for governments in the periphery (including Spain and Italy) to pay debts with credit markets shutting down, economic activity collapsing and policymakers either not responding or responding in a way that is likely to make matters worse.


  1. Hi David,

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  2. I wish people would stop going on and on about debt deflation. If you are uncompetitive, and have built up debt in a futile attempt to maintain your standard of living, then to get back to a sustainable position, you must cut your prices. This may appear to increase your real debt burden, but the truth is that your price structure was unrealistic anyway.

  3. David, this is a terrible development and the ECB keeps talking about inflation risks! One policy mistake agter another!

  4. Please look at how EUSWSB10 Curncy is actually defined. It is the difference between the 10y nominal euro swap and the 10y ZC inflation swap - that is, it is a read on real yields, not breakevens. The 10y ZC inflation swap (EUSWI10 Curncy) is currently arond 1.90 percent, significantly off of its local peak in April of 2.4 percent. But 1.9 percent expected inflation over the next 10 years is a far cry from 0.6 percent. This is careless, and does your readers a disservice.

  5. Anonymous,

    I took out the figure to avoid confusion.

  6. Actually, in that case (ie as anonymous says), you should keep the figure, because it shows that your post is diametrically wrong - it is real (highly creditworthy bank) euro interest rates that are at an all time low. Either that or just delete the post.

  7. Italian 10yr. govt. breakevens are about 95 bps, down from 240 bps in the spring. That's not a real rate, it's a spread.

  8. a) You should look at absolute interest rates: corporates currently finance in average in European Bond markets at an average of 3.4% in the 5Y tenor. If you think thats a high cost of funding, you should look at history.
    b) companies that cannot make a return of say 7% on their capital employed should close doors.
    c) whatever the central bank does, investors are not really willing to lend to corporates at these rates because they know these are ridicously low interest rates for corporates. Levels around 5-6% would be normal and 7-8% would start to harm to marginal borrowers. 3.4% is no tightening