ECB and the Euro

After sliding from mid-2014, the euro's bottom solidified last year when it became clear that the populist-nationalist wave that was said to be behind the UK rejection of the EU and the US election of Trump was not going to take control in Europe. There may be nothing like an uptrend in the euro against the dollar to stop cold the existential questions about the monetary union.

The Greek parliament passed new measures earlier this week that put in on course to exit the third aid package near mid-year. The members of the German Social Democrats will vote on January 21 whether to pursue negotiations for another grand coalition with Merkel and the CDU/CSU. Several regional conferences over the past weekend rejected the SPD leaders' efforts. However, if the SPD does reject a grand coalition, as the party leader Schulz initially indicated after last September's election, either a minority government or new elections would result, both of which have no precedent in modern Germany. Still, it is not seen threatening the German economy or EMU.

Last year's secession attempt by Spain's Catalonia was successfully outflanked by Madrid, which was forced to draw constitutional powers that have not been used before. A regional election last month saw the independent parties win a majority in parliament, but a little more than 10% of the seats are held by former leaders that are either in exile or in jail. The new regional parliament session formally begins today, but the selection of its leaders may still take one or two weeks. Madrid will not relinquish its direct rule on the region if the regional parliament insists on restoring the leaders that lead the secession.

The March election in Italy may increasingly draw the political spotlight. The new electoral law was to facilitate more stable governments, but it may not be sufficient. None of the three major parties/coalitions are drawing a majority of voters, leading to speculation of a new government coming from the center-right (Berlusconi party and the Northern League) and center-left (PD). The latest polls show the populist Five Star Movement with the most support, but it eschews coalitions and alliances. On the other hand, it appears the PD is losing support in the polls.

Renzi had moved the party in a centrist direction and alienated the left-wing. Despite the economic recovery, the PD is not getting much credit. In part, this may be because most Italians are not benefiting from the improvement. Polls suggest that more than 3/4 of Italian think the economic situation is bad. Underappreciated by many, more than 70% of Italian households own their homes and prices are falling. Property-related loans are accounting for a growing part of the bad loans at Italian lenders.

The political backdrop, even if we include Brexit or the ongoing tensions with Eastern and Central European EU members, has not stood in the way of a broadening regional recovery. However, as has been the experience of most developed countries during the recovery and now expansion since the crisis, price pressures remain troublesomely low.

This was driven home by the final eurozone December CPI reading. The headline slowed to 1.4% from 1.5%. CPI slowed even as the eurozone economy recovery broadened and deepened. The eurozone's CPI rose at an average year-over-year rate of 1.6% in H1 17 and 1.4% in H2 17. The core rate rose 0.9% every month of Q4 17 and average 1.2% in Q3 17 and 1.1% in Q2. The December 2016 print was 0.9%. The rise in price pressures last year was mostly a function of energy prices.

Since the ECB's staff forecasts last month, the euro is stronger and oil prices are higher than assumed. The strength of oil prices, if sustained, would boost headline inflation more than the euro's strength would dampen it. However, these conflicting impulses warn of higher headline inflation and softer core. That said, this month's headline reading (flash CPI is due January 31) may be impacted by the base effect as last January's housing and energy increase drop out of the comparison.

Over the last few days, several ECB officials have pushed back against the market's hawkish read of the record of last month's meeting. The policy direction and sequencing is clear. The risks of deflation have ended. Activity has strengthened and broadened. Inflation is still judged not to be on a sustainable and durable path toward the target. A rate hike will not be delivered until sometime after the purchases end. Most of the ECB has not been convinced by the hawks' argument to specify a date certain to end the purchases.

The current commitment (30 bln euros a month) extends until September. The ECB has explicitly linked its asset purchases to inflation. A pre-commitment to end purchases in September would, in effect, break the link and paint the ECB in a corner of date dependence rather than data-dependent. The ECB has not indicated the terms of exiting from its other extraordinary policies.

ECB officials have signaled the growing importance of its forward guidance. Yet, as ECB Vice President Constancio noted, next week's meeting may be too early to change the guidance much. The changes to prices (e.g., the euro and oil), and economic conditions more broadly do not warrant a significant change. The March meeting, at which the staff updates its forecasts may be a better venue.

During the euro's run last year, there were a few times that ECB officials seem to try to check the rise through commentary. On a trade-weighted basis, the euro has appreciated by more 1.85% from the middle of December through yesterday. If intervention is best conceived of as a ladder, the comments by the ECB are still the low rungs. The fact that among the most vocal hawks, Bundesbank President Weidmann is part of the chorus is interesting and may be part of his attempt to re-make his image as the contest to replace Draghi next year will begin in earnest toward the middle of the year when Constancio's term ends. Spain's Finance Minister de Guindos seems to be the favorite.

If de Guindos does get the nod, then given the multi-dimension balance that needs to be struck, Draghi's successor may be from Germany. It would seem like it is Germany's turn. The current term was ostensibly going to go to Germany's Weber before he resigned in disagreement with the majority of the ECB. Weidmann, who testified against the ECB before the European Court of Justice may be too divisive of a candidate. We have suggested that the ECB's chief economist, Praet, who was born in Germany, carries a Belgian passport may be an interesting candidate who is seen as more of a consensus builder.

There is no shortage of proposals for EU and EMU post-Brexit and post-crisis. A group of French and German economists has issued a six-point proposal under the rubric of the Center for Economic Policy Research:

• Limit the amount of its own sovereign debt a bank can hold and provide pan-European deposit insurance.

• Focus less on structural deficit targets and more on longer-term debt reduction goals.

• Allow countries to restructure their debt unless they meet the terms of crisis-lending vehicles.

• Create a common EU fund to help troubled member states.

• Create "safe assets" backed by national sovereign debt from around the region.

• Establish a non-political and independent monitor of fiscal policy.

The election of Macron, who campaigned on an unapologetic pro-Europe stance, and the possibility of another grand coalition in Germany in which the SPD demands a shift in Germany's European stance, would seem to favor a new initiative. However, it seems that policymakers, economists, and other observers are talking past each other. Some of the economists' proposals have been aired before, like a pan-European deposit insurance, that ran into formidable objections. Other measures, like a common EU funds to help troubled members, seems like the ESM, which some have proposed morphing it into the European IMF.

There is an Aesop Fable about belling a cat that is terrorizing mice. After a good hard think, and perhaps even dozens of policy papers, the mice agree tying a bell around the cat's neck is the best idea. When the bell rings, the mice can scurry. Unfortunately, the best-laid plans of people and mice often falter on implementation.