Christine Lagarde – a fresh beginning

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In her first major policy speech, new ECB President Christine Lagarde spoke of the risks that weak domestic demand and low inflation create for the eurozone.

  • Ms Lagarde called for a move to a new European policy mix to unleash higher rates of domestic demand and long-term growth. Fiscal policy (“today’s demand and tomorrow’s supply”) would be a key element.
  • The challenge now is to adapt economic policy instruments to the new environment of ultra-low interest rates and not get deeper into a rut.

Until this year, exceptionally low level of interest rates in the eurozone were arguably considered to be a freak and temporary occurence that would be swiftly resolved.

In recent months, that perception has changed as the European Central Bank and the US Federal Reserve have revised their strategy in favour of new interest rate cuts.

Low interest rates reflect weak underlying economic activity

This low level of interest rates is synonymous not only with a need to support economic activity, but more broadly with a lack of business opportunities.

This change of attitude is worrying because there is a risk it accelerates an economic slowdown. To avoid a vicious circle taking hold, Christine Lagarde, as new ECB President, will have to re-evaluate the efficiency of fiscal, budgetary and monetary policy in light of this risk. A strategic review of ECB policy objectives and tools was announced by Ms Lagarde in her first major policy speech.

The effect of the central bank´s different policy instruments depends on the level of interest rates. When interest rates near the lower bound, it does not just mean lending conditions are easier. It also reveals a lack of investment opportunities.

Structural factors are also at work

According to economic theory, the interest rate of equilibrium is a function of productivity, growth in the population and the degree to which consumers prefer spending now or in the future.

In the eurozone, productivity has slowed due to weaker investment since the financial crisis. Population growth is slowing as the population ages. These are structural factors contributing to the lower level of interest rates.

In addition, there are conjunctural factors. Firstly, decisions to invest depend not only on the cost of the loan, but also on the expected return. If interest rates are low over a long period, then sales revenues may well also be weak. Investments are postponed until there’s an improvement in prospects for growth signalled by a strong and permanent rise in inflation expectations.

Can ultra-low interest rates make matters worse?

The paradox is that low interest rates – initially considered to be a means of supporting the economy – become a source of recessionary worry.

In parallel to this, another recessionary phenomenon may result from negative interest rate as savings increase to compensate for lower returns. This is the paradox of thrift identified by Keynes (and referenced by Ms Lagarde in her speech on 22/11/2019). The impact, coming at a time when the economy is weak, is amplified.

In this new environment, reaction functions change. For example, in a low interest rate environment where growth is weak, a reduction in social security charges may be counterproductive. This is explained by the fact that as interest rates and inflation are correlated, a fall in the charges employers pay for social security allows companies to reduce their sales price to retain market share. That weighs on sales revenues, investment and can ultimately result in lower GDP.

A different approach

The eurozone economy would appear to be in a growth trap. The challenge for Ms Lagarde is not so much to recognise the inefficiency of the traditional tools and reject them as to adapt policy instruments to the new environment of ultra-low interest rates. Changing the perception of economic agents of the future is the objective. Further ECB interest rate cuts are likely not the appropriate policy tool.

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

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