16/12/15: 36 years of interest rates across major advanced economies

As we inch closer to the U.S. Fed rates decision today, here is a useful chart summing up evolution of interest rates in key advanced economies over the last 36 years:

Happy lifting... 

3/12/15: 85 v 52: Of Duration of Risk Mispricing

One of the causes of the most recent crisis in the euro area is frequently linked to the superficially low interest rates set by the ECB during the period of 2002-2006. Taking historical average rates, the actual period of significant interest rates deviation from the ‘normal’ was between 38 and 52 months, depending on how you measure it.

Since then, of course we’ve learned the lessons… so the current period of ECB rates below their pre-crisis historical average (using 1/2 standard deviation around the mean to control for significance) is… err… 85 months and counting. Oh, and by magnitude, the current deviation is much much worse than the one that caused pre-crisis mispricing of financial assets and risks.

Just check the following chart, updated to today’s ECB call…

Eye popping, no?.. say 52 months to blow the bubble up… 85 months to… 

03/11/2011: ECB rate cut

ECB decision to reduce rates by 25bps today has led to a dramatic reduction of the ECB overall rate premium over the basket of advanced economies rates as shown below. With today's decision, the ECB premium declines from 16.73% in October to 1.21% in November (barring any change in the BofE rate later).

This move, however, directly contradicts ECB mandate for price stability with inflation for October anchored at 3.0%:

06/10/2011: Has ECB done a sensible thing, at last?

Like a heavily Photoshopped version of Bill Gates can be expected to last, oh about a nanosecond in convincing the generation i-Apple of the need to buy Microsoft products, so did the interest rate’s junkies expectation that the ECB is about to drop rates to where Ben “The Helicopter” Bernanke has them proved to be short-lived.

Today’s decision  by the ECB not to alter the existent rates was both a shock to all those incapable of making a living in the real economy stagnated of cheap liquidity and to those who were expecting the ECB to miraculously discover some latent propensity to fuel inflation.

Yet, the decision was perfectly in line with ECB’s policies to-date. Worse, it was in-line with rational ECB policies to-date – the type of policies that should be predictable from the long-run perspective. ECB has held its nerve this time around. Here’s why.

Chart below shows the historical path relating ECB rates to the leading indicator for real growth in the euro area, eurocoin.

At the depth of the crisis back in 2009, rates consistent with the current eurocoin reading were justifiably lower than they are today because they were coming on the foot of severe contractions in economic activity from the tail end of 2008 and into 2009. In addition, monetary policy at the time was accommodative of growth recession, rather than of the banking and financial services crisis or the sovereign crisis. Today, the picture is different. While eurocoin has entered the period of signalling potential for renewed recessionary dynamics, the looming growth crisis is not underpinned by the change in economic fortunes for the euro area, but by a set of structural weaknesses (fiscal, banking and credit supply-related, depending on the specific country). Easy monetary policy can help, but it cannot restore the euro area economies to structural health. Instead, alleviating the pressure on growth through monetary tools can only delay the necessary adjustments in structural parameters. ECB is not about to do this and, perhaps, for a very good reason.

This means that the current leading indicators scenario should be compared not against 2008-2009 period, but against pre-crisis periods where eurocoin had also fallen to the current levels around zero. This is the period of December 2002-June 2003 and the underlying ECB repo rate at that time was around 2.5%. Get it? The policy-consistent move for ECB today would be from around 3% down to 2.5%, not from 1.5% to 1%. Given we are at 1.5%, the most consistent move would be to stay put. And this is what the ECB chose today.

By the way, in the long run, since eurocoin is the leading indicator of activity, there is a negative relationship between inflation and the growth projections it provides: higher growth signal into the future tends to coincide with lower inflationary pressures today. Or put differently, falling eurcocoin now is not necessarily a signal for well-anchored short-term inflationary expectations, something that coincides with the stated ECB concern expressed in today's statement.

Of course, ECB targets are set based on inflation, not leading growth indicators, although the two are strongly correlated with lags. Here, the same picture applies:

And the same logic holds. So based on inflationary dynamics, the ECB repo rate should be around 2.0% to 3.0% and falling from above 2% levels, but not below 1.75%. Given the starting position at 1.5%, a rational move would be to stay put. 

No surprise, then in today's decision. It could have gone like 25:75 - with lower chance for an irrational knee-jerk rates lowering reaction on the foot of the immediate crisis, and higher chance of what has been delivered.

Perhaps the only disappointing bit to today's ECB call is that the central bank will continue supplying unlimited liquidity to the insolvent banking sector under unlimited 1mo lending extended through July 2012. Perhaps the ECB had no choice, but to do that. Or may be a better option would have been to start properly assessing the quality of collateral pledged by the banks at the discount window. That would have achieved two things - simultaneously - both being good in the long run for the euro area banking sector:

1. It would have continued provision of supports to the banks with better quality assets (aka solvent but stressed banks), and
2. It would have put pressure on member states to purge their sick banks and drastically restructure the banking markets (getting rid of Dexia-esque zombies).

On top of that, ECB announced renewal of LTROs (12-mo and 13-mo) with delayed interest cover - in effect a heavy duty support for really stressed banks. Last time ECB did this was back in December 2009 and those operations were designed to shore up banks in the wake of the Lehman Bros bust.

Instead of applying some pressure on euro area's clownish 'leadership' in the banking sector, the ECB choose to call for some unspecified efforts by the banks to voluntarily shore up their balance sheets and retain earnings to provide cover for losses on their sovereign bonds exposures to weaker euro area countries. In the current climate, and with ECB providing unlimited liquidity, this is equivalent to suggesting that zombies should get out into the yard and work-off some of their rigor mortis. Good luck.