Saturday, 29 March 2014

Understanding ECB Comments: How Central Bankers (Should) Think

Central Banking should come with a warning: Anything you do, will be the cause of major criticism. When I usually see reactions on comments by ECB officials, it usually of the "they know nothing/understand nothing kind". The job is not easier for the US Federal Reserve either; it has a long been a while since I've heard no reactions to policy changes. When the Fed initiated QE, Cassandras said it would drive inflation rates sky high; it didn't. When tapering started, Cassandras (different ones I hope!) complained that it would have a severe effect on the economy; still nothing. Yet, while the usual aphorisms on Central Bank statements and actions have been going around for a while, what is usually the problem is that do not see things from their point of view: that of a person/institution who have a great effect on the economy.

Whether we like to admit it or not, Central Banks do have a lot on their minds. When times are good they have to be careful to prevent bubbles from forming and when times are bad they have to act in order to make them better and be careful not to make them worse. A clear example of the Central Banker's power and the strong grip he or she has on the economy, are reactions to verbal statements. When Alan Greenspan spoke of irrational exuberance for the first time in 1996, markets tumbled; when Mario Draghi gave the "anything it takes to support the euro" speech in August 2012, this is how the Forex Market reacted:
It is really not a question whether the Central Bank has an effect on the economy, it's about how big it is and the answer is that it's huge. Even if policies do not drastically change market conditions in the short-run  (they usually change them in the medium-run), comments and speeches do have a stronger effect since they affect investor confidence. This is why Central Bankers are very careful of what they say and this is why they should (and do) never speak of bad news.

As we know, the ECB, through its Board, has denied that deflation is a problem. Jens Weidmann has stated that the drop in inflation is nothing but temporal. Whether he actually believes that or not, is something we will never find out. Now, dear reader, imagine what would happen if the ECB or it's board began to talk of deflation being a problem in the Eurozone. As a first reaction, markets would drop and the euro would rise making exports harder. Investment would gradually be reduced and the whole economy would enter a vicious cycle of decreased consumption, drops in wages and less investment. More so, the whole procedure could actually be initiated just by the Central Banker admitting that deflation exists, as most people "know" that deflation is a problem.

Then, with regards to ECB reactions and comments, what would the reader, an ordinary citizen of the Eurozone prefer: a Central Banker denying the existence of deflation thus allowing the markets to continue without paying attention to what he says, or a Central Banker admitting or warning about the dangers of the current deflation and forcing a deflationary cycle on the economy? If you ask me, the former is much better than the latter, if only for employment reasons.

Who knows: maybe the ECB does know something more than we do when it comes to deflation. If not, then measures to counter deflation can be expected at the next meeting. Still, too much truth can actually harm the economy at times. In fact, I would even go as far as claiming that a Central Banker should act like Titanic's orchestra: even when the ship is shipping (s)he should calm everyone down and tell them that it's all going to be all right.

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