European Central Bank

If 2% Is The New 4%, Where Would The Economy Go From There? Let’s Think It Uber!


One of the most provocative articles in the financial media relating the economy in recent weeks was a brief note by CNBC contributor Ron Insana — one of the folks on that network who consistently knows what he is talking about  —  calling attention to the determination of the major central banks to treat the threat of deflation (not inflation) as pubic enemy number one in a battle he concluded would last as long as the decade it took to bring inflation to heel in the 1980’s in the US. And if he is right in his thesis, we probably need to re-examine the conventional premise that, if and when the central banks succeed in bringing economic conditions back to normal, would that really mean a base interest rate of around 4% as in the past, or would a number much closer to 2% be the new normal? And how would that change our perspective on likely economic behavior around three major pillars of US economic activity: housing, autos and finance?

Insana’s point was brought home the same week by the extraordinary policy actions of the European Central Bank (ECB) cutting its base interest rate to .15% from .25%, and reducing the interest it pays on deposits with the Bank to a minus .10 %, as well as a new targeted long term refinancing operation to inject even more liquidity into the system in the face of persistently low inflation to try to stimulate more economic activity to boost Euro Zone GDP out of its near-zero state.  In the words of London’s Financial Times on June 5, this was a “bazooka” move that would reinforce market perceptions that the ECB would actually keep its commitment to fight the real potential of a deflation spiral that has flattened the Japanese economy for over a decade. Markets first reacted skeptically by bidding up the Euro, but that short term move eased off as economic data continued to come in toward negative growth.

Remember: inflation erodes the purchasing power of the country’s currency and tends to favor debts – they pay back their bonds with cheaper money, so lenders demand higher interest rates to compensate. But deflation erodes wages, prices and asset values (like stocks and houses) so it also has a negative effect on purchasing power despite the lower prices that go along with it. Central banks have proven they can whip rampant inflation (at the cost of high interest rates and recessions if necessary), but are only experimenting with how to reverse deflation because they know their tools are limited. There is only so low interest rates can go – even into the negative – while rates can be raised to a theoretical infinity (Paul Volcker in the US got them to 20% for a time, as Insana points out, but he won the battle and the war against severe monetary depreciation.) It’s understandable that central banks would want to nip deflation in the bud. Volcker’s war took ten years; why would we expect a harder battle against deflation to take less time? If so, one begins to consider the possibility, along with Insana, that low rates will be with us a lot longer than most expect.

Eurobond prices have surged to new high, bringing interest rates down to levels not seen since Napoleon’s time as the market has been warning of incipient deflation – and to some degree betting that ECB President Draghi will be forced to a full-blown “quantitative easing” bond buying program as in the US. He signaled again he might be inclined towards this with his “we aren’t finished” statement accompanying the recent rate cut decision. In that event, today’s expensive looking Eurobond purchases will look cheap when the holders sell out to the ECB at even higher prices! So we can see the trap Draghi is caught in — the more he does to combat deflation (which he must lest Europe return to recession), the further he drives down rates with programs that will tend to keep interest rates quite low. In turn, such low rates put a downward pressure on US interest rates as investors pay up marginally for a safer bet on government and corporate debt here. Whatever one’s questions may be about the absolute strength of the US economic recovery, no one seriously argues that it is not far stronger relatively than Europe’s, even with our wintry negative growth in Q1 2014. Europe would pay ransom to get the 3%+ growth now expected for the US in the current quarter.

 Despite this resurgence in growth, the US Federal Reserve is expected to maintain its tapered pace of reductions in bond buying and has insisted that even after that program ends and unemployment is reduced to .5% or better in the coming year, it nevertheless will not quickly move interest rates up to track the growing economy. Even if inflation hits 2%. It stated after its last meeting on April 30 that economic conditions may “for some time” warrant keeping the base interest rate “below levels the Committee views as normal in the longer run”i.e., 4%.

 If CNBC’s  Insana is right that the “longer run” path to vanquishing the threat of deflation could take  at least a decade, then the Fed is only half way there now, and halfway to 4 is indeed 2. Seasoned investment managers like Mohammed El-Erian, late of PIMCO, have begun referring to “lowflation” fears as pressuring bond yields and Central Bank rates down. Although El-Erian said in the Financial Times on June 6 that he believes that the policy moves should ultimately result in a “self-correcting”  move out of bonds riskier assets, thus normalizing rates to the conventionally expected levels, he does allow that the move downward in rates could also become self-reinforcing due to unforeseen events (like Ukraine). If that is the case, the sense that 2% might become the “new” new normal (ironically, a nomenclature first traced to El-Erian and PIMCO) that needs to be taken seriously.

 Here’s what could happen. While mortgages would be cheap, price appreciation expectations for homeowners would be significantly reduced. A long battle with deflationary tendencies would make renting more attractive as an ordinary feature of middle class life, simply because it is economically smarter. Similarly, not owning a car might become more of a new normal, especially when Uber is replacing a taxis and has an $18 billion valuation in just five years of existence. Maybe the millennial generation sees what is coming. Better not to be an owner if deflation threatens the endurance of asset values.

 Finally, financial institutions would have to come to terms with the constraints of the Dodd-Frank law and find new wisdom in Shakespeare’s “neither a borrower nor a lender be” and drift toward Ben Franklin’s “a penny saved is a penny earned.”

Renting a house, snagging a ride on your smart phone, and de-leveraging your balance sheets would truly be a new American way, with tremendous implications for policymakers including the Fed if a geopolitical or natural disaster hit and it was stuck at an already low interest rate.   As noted investor Ray Dalio –- who is very familiar with the roots of the current Euro-deflation crisis – said, this situation would leave the Fed with little leverage  itself to stimulate an economy under attack. Then we could indeed all be Japan! The first clues to whether we are headed in this direction will be to ‘connect the dots’ in the Federal Reserve members’ interest rate projections over the next couple years that will be released as part of their quarterly economic forecasts at the June 18-19 meeting. Here’s a bet there won’t be many 4%ers and more than a few 2%ers.


Recently published on The Huffington Post





By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University


Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.







Europe vs US — Will QE on the QT by the ECB Save the Year?

In the US for most of 2011, the words of Pogo the Possum have prevailed in our political economy:  “We have met the enemy and it is us.”  This reality was most evident in the gridlock in Congress over budgets, debt and taxes that endured for almost all of this past year, culminating in the recent momentary stalemate  over the extension of the payroll tax cut into 2012. We get the Congress we deserve. And despite the frequent media commentary that cites a national desire for compromise and deal-making between the parties, the politicians with their ears closest to the ground hear a firm insistence on intransigent from their most loyal supporters (and campaign funders). Fortunately,  our situation can be changed for the better by a shift  in public sentiment that in turn changes political will — and this in fact happened on Christmas night at Speaker Boehner’s House. For once, the polls showed the pols that voters were backing-off their love affair with “lines in the sand”, and we got a deal.

Europe, on the other hand, remains tangled in its own underwear: in particular, the German strict construction of the European Union treaties to the effect that the European Central Bank can never act as a “lender of last resort” to its sovereign states, even to prevent a financial panic and  the collapse of the Euro currency. (German authorities seem to be most fond of enforcing the rules they themselves are the first to break: originally, by violating the Euro limits on national debt; and now, by their own political interference in ECB decisions, which they separately argue should be “independent” from such influence  –at least from other governments.) In effect, if the German position is not merely a negotiating posture to force recalcitrant Mediterraneans to get their budget acts in good German order — as many market participants seem to hope — the Euro currency is essentially a suicide pact!

All this could come to a head as soon as the first quarter of 2012 when Italy and Spain are forced to refund billions of maturing debt. At prevailing pricing trends, they cannot afford to do so without bankrupting their budgets. They need a financial  backstop to effectively put a lid on their sovereign debts’ interest rates by massive and timely market intervention — exactly what the Germans say the ECB cannot do.

Among Europe’s financial eminences, only the semi-disgraced Dominique Strauss-Kahn  seems to understand just how serious the situation is, but he is effectively without political force.

As we approach year-end, however, the ECB has attempted an elegant  hook-slide around  Germanic obstinacy by extending to three years its virtually unlimited lending facility to EU banking institutions at a rock-bottom short term rate that normally applies only to very short term borrowings. This yield curve tinkering –let’s call it QE on the QT  by the ECB — enables these banks to hold on to their existing holdings of Eurozone sovereign debt purportedly to maturity, thus deferring further write-downs impairing their capital or  the dumping of such bonds on a highly nervous market. It also invites the banks to buy into the refunding rollovers due. $500 billion of this offer was taken up by Europe’s banks, and another opportunity will be in place by February to continue  shoring-up the banking sector, which in turn helps the sovereign sector (which would have to bail out failing  banks to prevent Lehman-lke economic collapses int their economies).

The main fly in the ointment as we end 2011 remains the rating agencies’ posture toward Euro sovereign credits. These agencies collectively failed to downgrade the  US mortgage debt instruments that brought on our own financial meltdown in 2007 and the Great Recession that followed. They now seek to display their new-found backbone by following up Standard and Poor’s questionable downgrade of  US  credit on political grounds with threats of downgrading Europe’s safest credits, including France and Germany.

Ironically, a quick-trigger downgrade in Europe in early 2012 could have the same effect as the slow trigger in the US of 20005-07 — a massive collapse of global confidence this time in Europe’s financial structure, and a potential global depression along with it. If we are lucky, the agencies will notice the subtlety of “Super Mario” Draghi at the ECB — he may be the first Italian politician to outwit the Germans. As the US begins to sense its own economic recovery (look for a great jobs number on at the end of January’s first week), we can only hope this is the case.

Better Fed Than Dead

Terry Connelly is dean emeritus of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.


Traders ares speculating that the fed is bound to disappoint the markets on wednesday as there is really nothing much they can do tohelp the economy grwo any more, and nothing much that they can agree on in any event. I think they are wrong, on both counts.


As to the second matter first — Ben Bernanke’s background is not in the corporate world, where a Board of Directors, like the Fed’s Open Market Committee at least in structure and mission, is expected to be unanimous or nothing at all. Instead, the Chairman’s background is steeped in academic strcuture. Like any dean of a strong minded faculty (including myself, although I have lived in the other world of business, too), he knows that no faculty is likely to be unanimous about anything, and it does not bother him particularly even he has two or three public dissenters to Fed policy. And he gets great marks from his colleagues for courtesy and openness. Most faculties prefer to debate more than decide, anyway, because down deep they have mutual respect for their diverse opinions, no matter have pointed their disagreements. Ben will do a deal with majority support and not hold out for the “perfection’ of unanimity. You don’t have a specially-extended  two-day meeting and then do nothing; unless you want to contribute to market carnage.


And what ‘s to be done? Lengthening the maturity of the Fed’s balance sheet (the so-called “twist’) was sexier  when it was really just a teenage dance move, but it would help hold down longer-term interest rates that are the base for mortgages and consumer loans. Lowering the interest rate it pays banks to keep their excess reserves on deposit with the Fed will also help at the margin to push them to lend, finally. (This step should be staged to prevent a huge washover of deposits into money market funds and risking their valuation.) Both these moves would be welcomed by the financial markets, especially in terms of reducing the current obsession with every choreographed move in the Greek default process, as the “troika” of EU. ECB and IMF negotiators string bailout approval VERY PREDICTABLY BUT ALSO INEVITABLY  to the last minute so as to hold in check the negative public  opinion in Germany about spending more money on the Greeks. (They cannot afford to be scene as anything other than the strictest of lenders, so they drag things out to create that impression while the markets forget that it was just last week that Merkel and Sarkozy said the deal would get done! Traders can be downright stupid at times.)

And, by the way, don’t let this loose talk that we’d all be better off just to let Greece default right now (rather than waiting until 2013 when the lead countries of the European Community get their banks in shape to sustain losses in a managed default) get the better of your memory. That’s what folks said about “letting Lehman fail” before the great mistake (predicted in this blog) that triggered the Great Recession. Moral: don’t listen to the drumbeat on CNBC, ever!