The ECB, OMT and Inflation

Today saw the EU court ruling on OMT (Outright Monetary Transactions) essentially allowing the ECB to continue with OMT and potentially further QE. So I wanted to do a bit of an explanation around the challenges facing Europe.

What is OMT?

Outright Monetary Transactions (“OMT”) is a program of the European Central Bank under which the bank makes purchases (“outright transactions”) in secondary, sovereign bond markets, under certain conditions, of bonds issued by Eurozone member-states.

Source: Wikipedia

 

First, let me explain why the OMT ruling is is so critical.

The ECB’s primary mandate is to hit inflation expectations / target of 2%. The reason for this, is that there is a broad-based understanding that 2% is a good number that allows wage growth and economic growth, without the risk of being able to slip into deflation too quickly or without creating a bubble.

Now inflation in general isn’t actually that positive. It essentially means the money in your pocket you had yesterday is worth less today, as things cost more today.

But worse still is deflation, that is when inflation goes negative, as the challenge here is it leads to a typical deflationary spiral.

Lower prices lead to lower demand, lower demand leads to lower production, lower production leads to lower wages, lower wages leads to lower income, lower income means less spending, less spending means lower prices…

And we all end up with less money and in a bit of a mess.

Now typically your main control for inflation is interest rates. You raise or lower interest rates to spur the economy, the idea being that if you lower interest rates debt is cheaper and people can afford more and so spend more, thus increasing demand which leads to higher prices, more supply, more wages etc…

If you raise interest rates then obviously the counter is true.

Now the ECB has a problem, as they can’t lower interest rates. So they have to try and stimulate the economy in other ways.

Now, if you are Carney at the BoE or Yellen in the Fed, or numerous other central bankers who can in fact operate QE, you buy debt (typically in the form of government), and sometimes corporate bonds, thus stimulating the economy that way. In theory, this frees up the major holds with more cash which they then flow into the economy.

The problem has been that under-capitalised entities such as banks have lead to poor transmission of the money into the economies. Essentially people are rightly more risk adverse.

So Draghi is now talking about more QE and given that this is their only tool, they need to do something. Sitting in deflationary environments like this typically only results in impacts in further generations as the spiral increases.

Draghi’s problem is how do you do that fairly and consistently across the Eurozone when each country has very different yields and rates of debts, and how effective will it be?

Remember you will also impact inflation in the individual countries. Therefore if you have a country with nice low inflation (good) and you start purchasing bonds will you knock them into deflation (bad). What happens if that country was recovering well but is the best way to stimulate the rest of Europe? Do you sacrifice one country’s recovery to potentially help the others? Ok, so now what if that country is Germany – your shining star in the Eurozone?

…You can soon see how this gets messy really quickly.

The up shot to all of this is that doing QE in Europe is either ineffective or takes a long time to get right, and it’s an experiment we don’t have any real prior evidence for.

No-one really knows how effective this will be, but they are running out of options bar starting to break up the Eurozone into smaller segments and devaluing currencies in specific parts.

Got a question for Sam about inflation, the ECB, OMT or anything else on Forex? Got a request for an educational article? Catch him in our Trader Hub, or tweet him at @LFXSam.