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Hawks and DovesBy Riccardo Russo (in cooperation with prof. D.Masciandaro).

Which resolutions may we expect from the ECB Board meeting next Thursday?

It is likely that Mario Draghi will still wait and see. The ECB is characterized by a well-defined mandate: to maintain inflation below but close to 2%.  It is also clear what tools it has available: the ECB is engaged in a very aggressive monetary expansion. Given this, the Bank is waiting for data from inflation and growth. The more positive the signals from these figures, the stronger the commitment to stick to expansionary stands will be. Perhaps there will be new decisions in December, but the next deadline for the ECB to reconsider its policy will be in March 2017.

Up to now, has the European QE worked?

I think it is important to remember why Mario Draghi decided to implement a QE. With this unconventional monetary policy, the ECB is purchasing 80 billion € per month in public and private securities. The ECB realized that the conventional monetary policy alone was ineffective. In other words, Europe was in a liquidity trap: this means that – given the chain between monetary policy and real growth – we have some links that do not work. The general explanation is that the more uncertain the scenario is, the higher risk aversion is. Of course, this leads all the players – households, firms and banks – to “fly to quality”, which means moving to liquidity, the less risky asset by definition. It is straightforward that, the more you run to liquidity, the weaker the positive relationship between expansionary monetary policies and investments becomes, i.e. aggregate demand. To exit a liquidity trap, you have to change the monetary policy transmission chain, and the trick is trying to affect expectations. The public must be convinced that there will be higher inflation in the future. If the public trusts you, there will be a higher probability of increasing purchases of goods and services today. More than once, Mario Draghi claimed that in Europe the situation is currently approaching normality. Nevertheless, it is perhaps too early to understand if we are definitely out of the liquidity trap. When we are, we will claim the QE has been a successful operation. According to the ECB projections, the inflation rate will again be close but below 2% in 2018.

For the first time in history, one Pound, net of commission, is sold for less than one Euro. Is this a threat to the European economic recovery?

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First of all, we have to clarify that the consequences will be more medium termed rather than short termed. From an economic point of view, Brexit means a change in the rules of the game for trade. A standard result of economics is that the less globalization you have in trade, the more likely losses in terms of output growth are. Therefore, Brexit will be a driver of lower output growth in the UK in the following moths/years, rather than weeks. In these weeks, the consequences on the financial markets were relatively small. There was a shock just after the result, but then the Bank of England’s promise for an expansionary monetary policy in case of turmoil reassured investors. To put it another way, the BoE is smoothing all the possible short run hard consequences of Brexit. I would say that the current dynamics of the Pound is just a consequence of the anticipation that the future UK output growth will be lower. On the other side, consider that the devaluation of the Pound is not bad news for Great Britain since it is now running a current account deficit.

Will the FED hike interest rates before the end of the year?

All the attention of the media is focused on the decision about interest rates. I guess that a change of 20-25 basis points is not the very relevant point, the real news would be a change in terms of strategy. So far it is very difficult to identify a strategy in the FED’s actions. Let’s compare the FED with the ECB. The latter has a very well defined monetary strategy; the opposite is true in the case of the FED. From an institutional point of view, it would be necessary to have a rule specifying – for instance – which is the goal in terms of inflation and unemployment. Nowadays the FED’s commitment is just in terms of inflation, which in the US, as in Europe, should be close to but below 2%. No target is given in terms of unemployment. The FED has no strategy; we only have a general statement by Mrs. Yellen claiming that the FED policy is data dependent. Yet, we have no specific knowledge of which data the Bank is looking at. Such a lack of specification and clarification leads to an exaggerated discretion in the action of the central banker and poor information provided to the markets. Discretion in general is not a good thing. We must remember that the dollar is still the main international currency, thus we need a clarification of the strategy of the Central Bank’s leader. One possible explanation for this discretion could be a political one: the incumbent presidential elections may push the FED to prefer avoiding to be explicit, though, this is not a good reason from an economic standpoint. There is one more behavioral explanation: the more you are loss averse, the more you prefer the status quo. Putting together high economic uncertainty, political reasons and possible behavioral biases, we could understand this fed strategy. At the end of the day there may be a hike in the interest rate but the real news would be to have an explicit strategy decided and implemented by the FED after the presidential elections. Still, let me remark that the more discretion the central bank holds, the more likely it is to be attacked by the political establishment. In the first presidential debate, Mr. Trump explicitly accused the FED, addressing its expansionary monetary policy as a gift to the democrats. Now, is it a gift or is it not a gift? Are there political reasons to have such an expansionary monetary policy or just economic ones? Maybe both? If there is no clear strategy and mandate, it is easy for a Central Bank to be attacked. Claiming to be data dependent is not a strategy, this is just a justification ex post with no underlying economic rationality. There is no more powerful central banker than the one whose hands are tied.

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Before March 2017 the UK will trigger article 50 starting the Brexit process. Should we expect the Bank of England to further lower interest rates?

The problem is that we do not know when the Brexit will occur. There will be a lot of uncertainty at least for the following two years. I can foresee that the Bank of England will follow the same strategy central bankers adopted in the very aftermath of the referendum results. They will announce to the market that they will be ready to act using any possible conventional and unconventional tool to avoid two problems: economic down terms and financial instability. We thus know the BoE is ready to undertake even more aggressive expansionary OMO. Nevertheless, I think that in this year we have learnt a lesson: perhaps the central banks are very effective in addressing and fixing financial instability issues pumping money into the system, but this problem is just the short term one. The more challenging one is to trigger economic growth in the long run. If you think about all the QE experiences – US, Japan, EU, England etc. – it emerges how central banks are actually able to fix financial instability problems. This is less effective in terms of growth. The lesson is that in order to achieve economic growth, implementing – also aggressive – expansionary monetary policies is not enough. We need other kinds of policies. This is the mantra of all central banks but it actually reflects reality. In the short term, you need expansionary fiscal policies provided that your public debt is not so high. In a longer prospective you need structural reforms. More flexibility in the labour market, more competition in the market for goods and services. Going out of the economic perimeter, we could even find other kinds of potentially useful non-economic policies. Let me give an example: if you build up a good institutional reform you can have less uncertainty, more stability and – other things being equal – this may trigger higher output growth. Non-economic reforms can produce a positive effect in terms of economic growth. Of course, I am making no reference to the upcoming constitutional referendum in Italy.

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What could the reaction of the ECB be in case of relevant changes in the monetary policies of other central banks?

The ECB has no target with respect to the exchange rate levels. When setting the monetary strategy to follow, the ECB economists obviously consider the possible spillovers from the exchange rate market, but the ECB has no mandate on the exchange rate nor something like an “equilibrium” exchange rate level to preserve exists.

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