Email of the day (1)
“At a private meeting in Brussels this week, the governor of the Belgian central bank told us that the risks of inflation from the increase in the money supply are currently very low because the velocity of circulation is extremely slow. This use of the Fisher equation helps explain the thinking inside the ECB.”
Eoin Treacy's view Thank you for this piece of intelligence. A number of years ago, a friend at
the ECB explained their policy as focusing primarily on the velocity of money.
Many central banks follow a similar path; attempting to tailor money supply
growth to the requirements of an expanding or contracting economy. This approach
represents the academic culture of central banks as they attempt to smooth out
inconvenient data sets such as energy and food prices which affect just about
everyone. Here is a relevant section from a Bloomberg story
The inflation rate in the 17-nation euro area rose to 2.7 percent from 2.6 percent in January, the European Union's statistics office in Luxembourg said in an initial estimate today. Unemployment rose to 10.7 percent in January, a 14-year high, it said in a separate report.
Europe's economy may struggle to gather strength after shrinking in the fourth quarter as governments from Italy to Greece step up budget cuts, undermining hiring and consumer demand. While crude-oil prices have increased about 23 percent over the past year, companies may find it difficult to raise prices in coming months, economists said.
“Oil-price developments will be a key factor in future euro-zone consumer-price developments,” Howard Archer, chief European economist at IHS Global Insight in London, said before today's report. “But the likelihood remains that weakened economic activity and high and rising unemployment should generally limit underlying price pressures.”
I last posted charts of US M2, Velocity of M2 and their multiple in Comment of the Day on February 15th) . Unfortunately, we do not have access to similar data for the Eurozone. However, it is reasonable to assume that with a number of Eurozone economies contracting, or on a very modest growth trajectory, that velocity of money is weak.
The continuing difficulties evident in the European banking sector also act to retard the velocity of money. Against this background, the ECB has changed attitudes toward money creation and has lent in the region of a trillion Euro to the banking sector in the last three months. This policy has directly bolstered their balance sheets. Additionally, the easing of collateral requirements has created an arbitrage opportunity. Banks can buy sovereign European bonds at a discount and post them as collateral at par. They can then take out new loans and repeat the cycle.
As a result spreads for Italian, Spanish, Belgian, French and Austrian sovereign bonds over German Bunds contracted sharply from December. They all paused during February but extended their contractions today following yesterday's liquidity injection by the ECB. Breaks in the progressions of lower rally highs would be required to question medium-term support for these sovereigns relative to German debt.
The above spreads suggest a differentiation on the part of investors between the countries that received a bailout and those that did not. Greek spreads remain at elevated levels reflecting its tenuous position. The release of the latest tranche of bailout funds did nothing to soften investor attitudes towards the country's debt.
Portuguese spreads fell abruptly from late January but found support two weeks ago. Following a hiatus, the ECB was yesterday rumoured to have begun purchasing Portuguese bonds again, but this has so far had little effect on the market. With spreads currently near 1200 basis points, substantially more is required to bolster confidence in the country.
Irish spreads have paused near 500 basis points for the last month. The heightened sense of uncertainty surrounding the referendum on the fiscal treaty may curtail potential for additional compression in the short-term. 9-year yields have rallied for the last three days and while the gain has so far been mild a sustained move above 7.15% would break the three month progression of lower rally highs and suggest a return to supply dominance beyond the short term.
The ECB's recent actions have been aimed at supporting the banking sector. By changing collateral rules they have encouraged banks to buy European sovereign bonds. However, these actions may need to be followed up with additional direct purchases if spreads do not contract further.