Deflation fears as Eurozone and US credit contracts
News Article Date: Thursday 29th of October 2009
Data from the European Central Bank shows that the M3 broad money supply has contracted over the last six months, confounding expectations that ultra-low interest rates would soon boost monetary growth. Loans to the private sector fell 0.3pc from a year earlier, the first such decline since the data started in 1983.
The M3 figures include a wide range of bank accounts. They are watched closely by experts for early warnings about the economy a year or so ahead.
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Germany contracts 6pc as eurozone bank deposits fall at fastest rate since DepressionThe picture is even starker in America where M3 has shrunk at an annual rate of 6.5pc over the last three months, a pace of contraction not seen since the 1930s. US bank loans have plummeted since May.
Michael Taylor from Lombard Street Research said the eurozone was "blundering towards deflation". Inflation was minus 0.3pc in September, but unevenly distributed. Prices fell 3pc in Ireland, 1.8pc in Portugal, and 1pc in Spain. "All the ingredients are there for deflation next year. At some stage this may start alarm bells ringing at the ECB," he said.
The credit data on both sides of the Atlantic are hard to square with market expectations of a "V-shaped" recovery. Experts at the ECB and the Federal Reserve view the loan contraction as a short-term anomaly caused by the distortions of the crisis, and some have begun to hint that emergency stimuli will be withdrawn soon.
However, an ominous pattern is emerging where excess liquidity from low rates and quantitative easing is flooding into the equity (QE) and bond markets without gaining full traction on the underlying economy. This threatens to become a central banker's nightmare.
Otmar Issing, the ECB's former chief economist, told an Open Europe forum in London that policymakers are entering treacherous waters. "Nobody can be sure that we have a self-sustaining recovery. The challenges facing the ECB are tremendous," he said.
"Money multipliers have collapsed everywhere. What M3 is telling us is that confidence is missing. I don't see any way to stabilise M3 in such circumstances," he said.
Professor Tim Congdon from International Monetary Research called on the ECB to buy state bonds in a blitz of QE to insure against a double-dip recession. He said: "2010 is going to be very difficult."
However, any move to purchase EMU state debt would erode ECB independence and be viewed in Berlin as a monetary bail-out of Club Med countries. "They would enter a political minefield," said Dr Issing.
So far the ECB has confined itself to purchasing €60bn (£54bn) of covered bonds, a pittance compared to the Fed's actions. The assumption is that aggressive QE is not needed because the credit bubble in core Europe was less extreme.
However, there is a heated debate over credit conditions in Germany. Mittelstand family firms complain that the window for fresh loans has slammed shut. Savings banks are tightening credit to meet capital rules agreed at the G20 summit.
A report by Germany's five institutes said it was a error to push banks into raising capital ratios before the recovery is secure. "Financial conditions are likely to worsen further. Banks are facing large write-offs on toxic debt and a rising toll of company insolvencies. There is a major danger that already tight financing conditions could lead to a credit crunch next year," they said.
JP Morgan says European banks may have to raise $78bn (£48bn) in fresh equity over the next six months. BNP Paribas, Unicredit and others have already tapped the market, but some have dragged their feet – even clinging on to Icelandic bank debt at face value. Jürgen Fitschen of Deutsche Bank said lenders would face "major challenges" in the first half of 2010. "We are going to see some pain," he said.
Germany is competitive and will recover. The bigger danger lies in the South. Italy's public debt will reach 125pc of GDP next year. The country risks a compound interest trap. Nations can endure high debt, or deflation: both together are toxic.
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