Sunday, November 27, 2011

The Fateful Decision to Tighten ECB Monetary Policy

Paul Krugman notes that the Eurozone crisis began rearing its ugly head again back in April, the very time  the ECB decided to tighten monetary policy.  Krugman thinks these two developments are probably related:
By itself, that rate hike — although it was obviously, obviously a big mistake — should not have mattered that much. But maybe it acted as a signal of the ECB’s bloody-mindedness, and that’s what set off the panic.
I agree.  The market saw this interest rate hike as indicating the ECB would allow further weakening of aggregate demand in the Eurozone.  Consequently, the market lowered its forecast of nominal spending and, as a result, expected inflation started declining, the Euro began weakening, and sovereign spreads started increasing.  Here is the 10-year breakeven inflation expectation series for the Eurozone:    

Here is the nominal effective exchange rate for the Euro:

Finally, from Rebecca Wilder here are the surging spreads:

These figures show that these asset prices all took a marked change in trajectory at about the time the ECB tightened in April.  And all these asset price changes have been indicating tight monetary policy since that time, but no one at the ECB seems to be listening.  No one at the ECB seems to appreciate that by allowing aggregate demand to continue to weaken they are passively tightening monetary policy.  The Europeans seem to be repeating monetary history.


  1. David, I agree with your conclusion, but don't see how a depreciating euro indicates tight money.

  2. Scott, the Euro is weak because the Eurozone is weak which, in turn, is the result of the tight ECB monetary policy. So it is an indirect indicator.

    I see it as similar to the argument for why low interest rates can be a sign of tight money. That is, tight money causes economic weakness which pulls down the natural or equilibriuim interest rate.

  3. Scott,

    On further reflection I am not sure what I just said is consistent with a monetary disequilirium view so I will need to think a little more about it.

  4. David,
    The real yield makes this confusing. Currency movements are a function of (relative) real rate expectations. The Yen is strong because Japan real rates are thought to stay relatively positive. The Euro is weak because marktes expect the ECB to reduce real rates. Does this mean currency markets think the BOJ is "tight" and the ECB is "easy"?

    An alternative explanation is that Euro deposits have a rising risk premium that reduces the effective real yield. I think this has to hold true for German banks, but it does not.

  5. David,

    The Euro is weak because marktes expect the ECB to reduce real rates. Does this mean currency markets think the BOJ is "tight" and the ECB is "easy"?

    Going back to my original interpretation, the ECB will have to lower rates in the future because it is currently too tight.

  6. The case can be made that weak economies with tight policy exhibit (relatively) high real interest rates and strong currencies. This was true of the U.S. in 1932 and Japan today.

  7. Sorry for the slow response. I've thought about that possibility too. But it seems like forex markets assume tight money makes a currency stronger. And unlike with interest rates, the assumed effect (tight money means a stronger currency) is consistent with a classical flexible price model.

  8. On the depreciating euro: do the models referred to factor in risk of a currency collapsing entirely? Or, at least, its ambit of coverage (of countries) being uncertain?