Fotios Siokis
October 21, 2019

What are unconventional monetary policies? How are they implemented in the European Union? What does the future look like? In this article we address these questions. On September 12,2019, the President of the European Central Bank (ECB) announced a new monetary stimulus package, prompted by the entrenched low inflation rate and an economic slowdown that has proved to be more protracted than initially expected. The inflation and economic growth prospects in the euroarea, which were both revised downward to 1.2% and 1.1% for this year and 1.0% and 1.2% in 2020 respectively, have taken a heavy toll due to the persistent weakness in manufacturing and extraordinary uncertainty concerning international trading arrangements and geopolitical alignments.

A zero lower bound (ZLB) on the Main Refinancing Operation interest rate (currently at zero and equivalent to the Federal Reserve’s target rate) had eroded the use of traditional monetary tools, prompting the ECB to adopt unconventional measures. These were first introduced in early 2000 by Japan in its battle against deflation and had been previously employed in periods of heightened financial distress amid severe economic downturns, such as the recent Great Recession in the United States and the great sovereign and banking crisis in the euro area. Table 1 outlines these complementary monetary measures.

Table 1: ECB’s monetary policy decisions as of September 12, 2019

Source: ECB

Monetary Policy Tools Εxplained

1. Deposit (overnight) facility rate. Unlike the Main Refinancing Operation rate that remained at the zero level (figure 1), the deposit rate – the rate that the ECB remunerates for deposits that commercial banks hold at the central bank, in excess of the required reserves – decreased by 10 basis points, from -0.4% to -0.5%.

Figure 1. Deposit rate and the (a)synchronization of the main intervention rates
Sources: ECB and Federal Reserve

The negative deposit rate is a policy measure aiming at decreasing the yield curve at all maturities. It is designed to encourage commercial banks to lend their excess liquidity to households, firms, financial intermediaries, or to invest it in sovereign bonds, rather than to “stash” it in the Central Bank. Although this measure is intended to provide extra liquidity, critics argue that negative rates may adversely affect the profitability of the fragile European banking system. To the extent that a negative overnight rate reduces longer-term interest rates, the income that banks earn from interest bearing financial assets, such as bonds or mortgages, is reduced. Furthermore, the possibility that negative rates may lead to less lending and more risk taking by high-deposit banks cannot be ignored. Neither can the fact that negative rates could be passed on to corporate depositors and savers. For these reasons, the ECB introduced a two-tier system for the banks, under which a portion of reserves, set up to six times the mandatory reserves they hold at the Central Bank, will be exempt from negative rates and earn 0%, while the rest of the reserves will be subject to the -0.5% rate.

2. Forward guidance. Forward guidance occurs when Central Banks communicate with the public about the current state of the economy and the future path of monetary policy. By revealing the path of policy rates, the ECB seeks to influence longer term interest rates and to reduce uncertainty about the mean and variance of asset prices. Central Banks have used two types of forward guidance policy so far: the time- or calendar-dependent guidance and the state-dependent commitment. The ECB’s forward guidance announcement along with the deposit facility rate is state-dependent, conditional on the inflation outlook. The ECB states that as long as the inflation rate remains low and away from the targeted level (close to but less than 2%, as shown in the figure below), the interest rates and the other unconventional monetary policy measures will be accommodative. This is called an “Odyssean guidance” – a form of commitment where the Central Bank pledges to stay on course regarding the interest rate path and other accommodative measures.

Figure 2. Inflation rates in the euro area
Source: ECB

3. Quantitative easing (QE). This toolinvolves large-scale purchases of longer-term bonds by the ECB with the aim of easing monetary and financial conditions in order to boost spending. Purchases of government bonds increase their asset prices and consequently lower their respective yields. Asset prices and yields are influenced through two channels, namely the portfolio balance and the signaling channels. The first postulates–given that assets are imperfect substitutes–that purchases of longer-term government assets can also decrease the yields of other assets bearing similar credit risk and duration characteristics. In other words, the sellers of these bonds will seek to rebalance their portfolios by buying other assets that are substitutes for the ones that they have sold. This process will raise the price of other assets (wealth effect) and decrease their yields (lowering borrowing costs for firms and households as well as governments) an action that stimulates spending and investment. The signaling channel operates through the effect on expected future policy rates and can reduce the inflation expectations component (term premia) of long-term interest rates. In this respect, the QE measure is complementary to forward guidance, supporting the ECB’s commitment to stick with the announced accommodative policy. QE seems to have become a key instrument of monetary policy in the euro area which will embark again on asset buying on November 1 at a monthly rate of € 20 billion.  Based on the forward guidance rhetoric, QE is intended to last for quite some time and go beyond the €2.6 trillion bond-buying program that was first implemented and lasted through the end of 2018. But such actions are not harmless. QE could distress market conditions by diminishing the supply of long-term bonds in the market, and create a shortage of bonds that institutional investors and others used as collateral.

Figure 3. Yield curve in the euro area as of September 12, 2019
Source: ECB

4. Targeted, Longer-Term, Refinancing Operations (TLTRO). TLTROs are monetary policy tools that provide long-term loans to banks. The aim is to provide a favorable bank credit environment, enhancing support for financing the real economy. It will also ensure the smooth functioning of the bank lending channel as the main monetary policy transmission mechanism. According to the new TLTRO, banks can borrow up to 30% of their outstanding loans to businesses and consumers at a rate equal to main refinancing operation rate (0%). In cases where a bank sufficiently improves its lending to the real economy, the interest rate applied could become negative up to the deposit rate (-0.5%).

Discussion

The ECB’s announced measures aim to revive inflation expectations and bring inflation close to its 2 percent target level, something the ECB has fallen short of since 2013 and raised concerns about its credibility. In addition, the new monetary measures can spur economic growth by lowering longer-term borrowing costs for firms and households, and by providing an opportunity for Euro area member states to finance a fiscal expansion with very favorable interest rates.

On the adverse side effects of the unconventional measures, this ample liquidity handed to the banking system could easily be simply deposited with the ECB, or invested in higher-risk and higher-yield assets offered. To a certain degree, the downward movement of long-term yields in parts of the euro area, shown in Figure 4, is a testament to “hunt for yield.” By now the Greek 10-year bond yield, a non-investment grade asset is lower than the corresponding AA+ U.S. Treasury. As negative rates narrow banks’ margins, financial institutions could decrease lending and slow the economy. Core banks from Germany, France and Benelux, which account for 85% of excess liquidity, bear the bulk of the cost of these negative rates.

Figure 4. 10-year bond yields of selected countries
Source: Federal Reserve Economic Data (FRED) and Central Banks’ sites

What does the future hold? It is evident that the significant accommodative stance of monetary policy is set for a long time. Although the unconventional measures are mutually reinforcing, monetary policy alone might not be sufficient to revive growth in the euro area. The ECB has willingly passed on the growth baton to the member states, though most have applied austerity measures throughout the crisis and now seem reluctant to conduct a vital, expansionary, fiscal policy.

Paul Krugman
August 30, 2019

Remember the Vietnam quagmire? In political discourse, “quagmire” has come to have a quite specific meaning. It’s what happens when a government has committed itself to a policy that isn’t working but can’t bring itself to admit failure and cut its losses. So, it just keeps escalating, and things keep getting worse.

Well, here’s my thought: Trump’s trade war is looking more and more like a classic policy quagmire. It’s not working — that is, it isn’t at all delivering the results Trump wants. But he’s even less willing than the average politician to admit to a mistake, so he keeps doing even more of what’s not working. And if you extrapolate based on that insight, the implications for the U.S. and world economies are starting to get pretty scary.

To preview, I’m going to make five points:

1. The trade war is getting big. Tariffs on Chinese goods are back to levels we associate with pre-1930s protectionism. And the trade war is reaching the point where it becomes a significant drag on the U.S. economy.
2. Nonetheless, the trade war is failing in its goals, at least as Trump sees them: the Chinese aren’t crying uncle, and the trade deficit is rising, not falling.
3. The Fed probably can’t offset the harm the trade war is doing and is probably getting less willing even to try.
4. Trump is likely to respond to his disappointments by escalating, with tariffs on more stuff and more countries, and — despite denials — in the end, with currency intervention.
5. Other countries will retaliate, and this will get very ugly, very fast.

I could, of course, be wrong. But that’s how it looks given what we know now.

Let’s start with the scale of the policy. The Peterson Institute for International Economics (PIIE) generated a nice chart showing the escalation of tariffs on Chinese goods under Trump:

Average US tariff rates on imports from China before and after President Trump’s acts of protection

Source: PIIE

So roughly speaking, we’ve seen a 20 percent tax imposed on the $500 billion worth of goods we import from China each year. Although Trump keeps insisting that the Chinese are paying that tax, they aren’t. When you compare what has happened to prices of imports subject to new tariffs with those of other imports, it’s overwhelmingly clear that the burden is falling on U.S. businesses and consumers.

So that’s a $100 billion a year tax hike. However, we aren’t collecting nearly that much in extra tariff revenue: 

Customs duties receipts (in billions of Dollars)

Source: Federal Reserve Bank of St. Louis

Partly that’s because the revenue numbers don’t yet include the full range of Trump tariffs. But it’s also because one big effect of the Trump tariffs on China has been to shift the sourcing of U.S. imports — e.g., instead of importing from China, we buy stuff from higher-cost sources like Vietnam. When this “trade diversion” happens, it’s still a de facto tax increase on U.S. consumers, who are paying more, but it doesn’t even have the benefit of generating new revenue.

So, this is a pretty big tax hike, which amounts to contractionary fiscal policy. And we should add in two other effects: foreign retaliation, which hurts U.S. exports, and uncertainty: Why build a new factory when for all you know Trump will suddenly decide to cut off your market, your supply chain, or both?

I don’t think it’s outlandish to suggest that the overall anti-stimulus from the Trump tariffs is comparable in scale to the stimulus from his tax cut, which largely went to corporations that just used the money to buy back their own stock. And that stimulus is behind us, while the drag from his trade war is just getting started.

But why is Trump doing this? A lot of center-right apologists for Trump used to claim that he wasn’t really fixated on bilateral trade balances, which every economist knows is stupid, that it was really about intellectual property or something. I’m not hearing that much anymore; it’s increasingly clear that he is, indeed, fixated on trade balances, and believes that America runs trade deficits because other countries don’t play fair.

Strange to say, however, despite all those new tariffs the U.S. trade deficit is getting bigger, not smaller, on his watch:

US net exports of goods and services (in billions of dollars)

Source: Federal Reserve Bank of St. Louis

Adjusted for inflation, imports are still growing strongly, while U.S. exports have been shriveling:

Year-over-year percentage change in real (inflation-adjusted) exports and imports of goods and services

Source: Federal Reserve Bank of St. Louis

Why aren’t tariffs shrinking the trade deficit? Mainly the answer is that Trump’s theory of the case is all wrong. Trade balances are mainly about macroeconomics, not tariff policy. In particular, the persistent weakness of the Japanese and European economies, probably mainly the result of shrinking prime-age work forces, keeps the yen and the euro low and makes the U.S. less competitive.

When it comes to recent import and export trends, there may also be an asymmetric effect of the tariffs themselves. As I already mentioned, U.S. tariffs on Chinese goods don’t do much to reduce overall imports, because we just shift to products from other Asian economies. On the other hand, when the Chinese stop buying our soybeans, there aren’t any major alternative markets.

Whatever the explanation, Trump’s tariffs aren’t producing the results he wanted. Nor are they getting the other thing he wants: Splashy concessions from China that he can portray as victories (“tweetable deliveries”). As Gavyn Davies says, China seems “increasingly confident it can weather the trade wars,” and it’s not showing any urge to placate the U.S.

So, this might seem to be a good time to hit the pause button and rethink strategy. Instead, however, Trump went ahead and slapped on a new round of tariffs. Why?

Well, stock traders reportedly think that Trump was emboldened by the Fed’s rate cut, which he imagines means that the Fed will insulate the U.S. economy from any adverse effects of his trade war. We have no way of knowing if that’s true. However, if Trump does think that, he’s almost surely wrong.

For one thing, the Fed probably doesn’t have much traction: interest rates are already very low. And the sector most influenced by interest rates, housing, hasn’t shown much response to what is already a sharp drop in mortgage rates.

Furthermore, the Fed itself must be wondering if its rate cut was seen by Trump as an implicit promise to underwrite his trade war, which will make it less willing to do more — a novel form of moral hazard.

There is, by the way, a strong contrast here with China, which for all its problems retains the ability to pursue coordinated monetary and fiscal stimulus to a degree unimaginable. Trump probably can’t bully the Fed into offsetting the damage he’s inflicting (and just try to imagine him getting Nancy Pelosi to bail him out); Xi is in a position to do whatever it takes.

So, what will Trump do next? My guess is that instead of rethinking, he’ll escalate, which he can do on several fronts. He can push those China tariffs even higher. He can try to deal with trade diversion by expanding the trade war to include more countries (good morning, Vietnam!).

And he can sell dollars on foreign exchange markets, in an attempt to depreciate our currency. The Fed would actually carry out the intervention, but currency policy is normally up to the Treasury Department, and in June Jerome Powell reiterated that this is still the Fed’s view. So, we might well see a unilateral decision by Trump to attempt to weaken the dollar.

But a deliberate attempt to weaken the dollar, gaining competitive advantage at a time when other economies are struggling, would be widely — and correctly — seen as beggar-thy-neighbor “currency war.” It would lead to widespread retaliation, even though it would also probably be ineffective. And the U.S. would have forfeited whatever remaining claims it may still have to being a benevolent global hegemon.

A version of this article has been originally published in New York Times on 3/08/2019

Zhuo Xi
July 23, 2019

Starting from the different positions held by the Trump administration and the Chinese government on issues such as the bilateral trade balance, market access, and intellectual property transfers, China and the U.S., the world’s two largest economies, have been quarreling over trade for more than a year. This post reviews a number of measures of the recent performance of China’s economy to see if there have been any discernible impacts to date. The United States has initiated two rounds of tariffs on Chinese goods. In July of last year, 25% tariffs were placed on $50 billion of U.S. imports; in May of this year, a second-round raised tariffs from 10% to 25% on $200 billion of U.S. imports. President Trump has repeatedly warned that the United States may also place tariffs on another $300 billion in Chinese goods. China has responded with tariffs on $60 billion of U.S. goods after the May tariff hike. While tariffs have affected China’s trade, and investors are worried about the possible fallout that could hit companies, whole sectors, and other countries caught in the crossfire, the actual macroeconomic implications for China appear limited so far.

Direct Impacts

Source: OECD

According to recent data, China’s GDP has slowed to 6.3% year on year in the first half of 2019 (see above figure) feeling the pinch from the tariffs imposed. However, this view ignores that ongoingde-leveraging, real estate-regulation, and environmental protection have also caused significant downward pressure on China’s economy. In fact, China’s exports surged in 2018 a move that might be related to thefront-loading impactas exporters pushed out shipments ahead of the implementation of the latest tariffs, backed also by a weaker Chinese currency against the U.S. dollar. But, it’s uncertain whether the recent resilience of exports is likely to be sustained, especially considering that the higher tariffs on $200 billion worth of Chinese goods will soon take effect. In fact, both the World Bank and the International Monetary Fund (IMF) have lowered their forecasts for China’s future GDP growth.

Source: World Bank

Although the trade war between the two countries threatens to become much worse in the future, the direct impact on GDP is still limited in the long- term, since China’s economy is no longer mainly driven by exports. According to the data from the World Bank (above figure), exports accounted for roughly 20% of China’s GDP in 2017, down from 36% in 2006. Also, bilateral trade between the two countries contributes an even smaller amount to GDP. For China, U.S. trade contributes 2.5% to GDP while only 1% for the U.S.

Currency valuation

Source: FRED

Since China’s trade dispute with the United States, China has seen its currency, the renminbi (RMB), decline in value. Although the decline has not been as steep as that of the Turkish lira or the Argentine peso, whether China will also fall into a similar monetary crisis has been an important question for investors. Although the RMB is depreciating, one difference is that China has responded to the trade situation by allowing a moderate and controllable RMB depreciation. Generally, the policy has been to intervene and stabilize the value of RMB within the range (band) of 6 and 7 per US dollar. This should help Chinese exporters mitigate the impact of new tariffs, but it will cost the rest of the economy. In other words, contrary to other emerging market, the depreciation of the exchange rate is more intentional and controllable by the government.

The reason behind this trend is that China’s economic base and ability to control the exchange rates are hard to match in other emerging market countries. This point could be reflected by the recent variation of USD/RMB, where there was clear support when the rate approached 7. On the other hand, various Chinese financial governors have mentioned several times in the media that China won’t use devaluation as a tool in the trade dispute. The possible reason is that the internationalization of the RMB has been one of the top goals for Chinese financial development. In fact, the People’s Bank of China has just managed to successfully convert the one-way renminbi devaluation expectation of the market into the two-way currency fluctuation expectation in recent years. Based on these two considerations, a rapid depreciation of the RMB is not likely in the near future. However, if the trade conflict between the US and China has escalated to a financial war, then the possibility of strong depreciation cannot be ruled out.

Debt condition

There is a widespread view that an escalation of the tariff conflict could trigger a possible debt crisis in China and an increase of debt-to-GDP ratio due to deceleration of the GDP growth rate. But unlike the case of Turkey (and even Argentina’s), where the external debt position was almost 55% of GDP, equivalent to about 5.4 times the level of its foreign exchange reserves, China’s debt is mainly domestically held, while the external part is considered sustainable. Furthermore, China holds considerable USD exchange reserves-one third in the form of US Government securities-and given the slowly opening of its capital markets it can decisively control any capital outflow.

Impact on the Stock Market

The stock market is probably the place that will face the greatest impact. Global investors are worried about the continuous escalation of the US-China trade war. Since the beginning of 2018, China’s stock market has gradually fallen. At the end of the last year, the Shanghai Composite Index (SSE) once fell below 2,500, and the year-to-date decline was close to 30%. The trade dispute between the US and China had been one of the main causes for investor pessimism. To prevent a possible market crash, the top officials of the Chinese Government collectively called for stable expectations. In addition to the optimism over the prospect of a possible deal, the stock market bounced back in early 2019. However, immediately after President Trump increased tariffs on $200 billion worth of Chinese goods, the stock market has fallen sharply below 3,000 again.

Source: Yahoo Finance

Other Potential Impacts

In addition to the declining stock market, the impact of Sino-US trade frictions on China’s economy is gradually moving from the expected and psychological levels to the physical level, from local to global, including trade, investment, the supply chain, employmentand so on. For instance, the impact on the industrial chain cannot be underestimated; such effects are difficult to model quantitatively. For example, due to concerns about the uncertain future of the Sino-US trade war, more and more multinational companies are hesitant about continued investment in China and are gradually adjusting their global profile. According to survey reports, in order to avoid high import tariffs in the United States, large Japanese manufacturers have been re-examining their business strategy and have plans to transfer production lines out of China. The effects of the concern regarding a U.S.-China trade war can be reflected in the recent variation in the manufacturing PMI (Purchasing Managers Index): the PMI had declined to an annual low of 49.2 since the trade dispute. It rebounded back above 50 in recent months due optimism over a possible deal, but it fell again to 49.4 due to recent tariff hike.

The Purchasing Managers’ Index (PMI) is based on a monthly survey of supply chain managers across 19 industries, covering both upstream and downstream activity. The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change.

Source: The National Bureau of Statistics

The future of the US-China relationship will be essential not only for their wellbeing but for the global economy. Recent news surrounding Huawei and other Chinese tech companies suggests that the bilateral tensions between the two countries have expanded beyond the damaging trade war, and are headed for a keen rivalry in technology and innovations. With the APEC (12-member Asia Pacific Economic Cooperation) meeting in November, it’s possible for the U.S. and China to reach a “narrow” trade deal by the end of this year, but by no means to resolve all the tensions between the two countries. In the long- term, geopolitical experts have been warning that China and the US appear to be falling into the “Thucydides Trap”, which describes a situationin which a war between two countries is inevitable even though both nations may be trying their best to avoid it.