Deconstructing Trichet

Jean Claude Trichet responds to calls to cut the discount rate:

We are doing exactly what we judge appropriate to deliver price stability and to continue to anchor solidly inflation expectations.

Is it contradictory to [...] economic growth and job creation? We trust that it is not contradictory.

Let’s make the thought experiment that we lose the solid anchoring of inflation expectations.

Then we would have all our nominal market and long interest rates augmenting because they would incorporate the additional inflation that the market would anticipate in the future. Our own population will be frightened to see that they cannot count on a currency which maintains its value. And, more generally, confidence would disappear in a large number of constituents of economic agents.

So, to the extent that we are fully in line with our definition — close to 2, less than 2, we trust that we also contribute to the appropriate prosperity of the European Union.

Market Model

Trichet argues that central banks are incapable of setting a nominal interest rate as the market will add an inflation premium.

This is a bizarre belief.  If the expected time path of short rate is, say, 1% over a 1 year horizon, and inflation expectations are 3%, then Trichet believes that nominal interest rates will be 4%, not 1%.  He believes that nominal interest rates are set by investor preferences, and not by arbitrage with the discount rate.

What could be the possible model behind this view? If we are generous, then we might argue that Trichet meant to say the following:

“If the ECB starts acting randomly, then investors will not be able to predict future short rates, and they might assume [why?] that future short rates will be higher than we intend, causing longer term nominal rates to also rise. Therefore it is in the best interest of the economy that the ECB follows a policy rule, and this policy rule currently tells us not to cut rates, because we believe that if we do, it will cause inflation to exceed its target amount.”

But the first reason why Trichet did not say that, was that he would be forced to defend the policy in the light of high unemployment and low economic growth. In his defense, it would be revealed that he does not believe that there is such a thing as an output gap due to insufficient investment demand. If he did believe this, then the policy should call for cutting the short rate when there is insufficient investment. The increase in investment would increase output and (eventually) inflation, at which point the policy rate would be raised again.

Trichet does not believe in this Wicksellian dynamic.

Hence the statement “we trust that we also contribute to the appropriate prosperity of the European Union.” What he believes is some form of continuous full market clearing, which makes one wonder why he is involved in central banking to begin with.

Targets and Priorities

So, to the extent that we are fully in line with our definition — close to 2, less than 2, we trust that we also contribute to the appropriate prosperity of the European Union.

Note the “less than 2″. The second reason why Trichet did not make the more sensible statement that his reaction function does not call for rate cuts is that he would need to defend a reaction function that targets not a single rate of inflation, but an entire half-line.

If inflation rates less than 2 are also inline with the definition of price stability, whereas mass unemployment and low economic growth is in line with the “appropriate” prosperity of the eurozone, then we begin to understand ECB behavior a little better.

Our own population will be frightened to see that they cannot count on a currency which maintains its value.

Yes, the population is not frightened by decreased job security, high unemployment, cuts in pensions, and mass layoffs. They are instead frightened about the currency not being stable.

Perhaps Trichet, when he says “our own population” has a special definition, similar to his definitions of “price stability” and “appropriate prosperity”:

confidence would disappear in a large number of constituents of economic agents.

So this is what it all boils to — bond holders would be uncomfortable, they would be frightened by a decrease in the value of their currency. The incoherent economic model and shifting policy targets now make sense.

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4 responses to “Deconstructing Trichet

  1. Well done.

    Of course we’ve always known that TPTB really DO think that the “elite”, “bond vigilantes”, “pretty people”, “job creators”, “real Americans” (or their European equivalent) etc are THE focus of all economic policy, but its still nice to see it exposed in this way.

    THIS; “Yes, the population is not frightened by decreased job security, high unemployment, cuts in pensions, and mass layoffs. They are instead frightened about the currency not being stable” is the coup de grace!

    These people think money is more important than people.

  2. Excellent stuff, especially the conclusion.

    The big political-economic question, though, is why such solicitude for bond holders? That macro policy would be conducted based on the interests of the owners of wealth is not surprising (though not something to be passively accepted, of course.) But it’s not just that money is more important than people; it’s that capital in the form of money (or at least closer to money) is more important than capital in the form of productive enterprises. That is strange. And yet it certainly seems to be the case, when you look at the priorities of someone like Trichet.

    • If I was to be generous, the reason would be institutional, in that the ECB and eurozone more generally are vulnerable to bond markets in a way that a real central bank or a real economy is not.

      The ECB can suffer losses if there are bond defaults and has to guard its capital, as the bonds that the ECB purchases are sovereign bonds of governments that are at risk of default. There is no such thing as a risk free euro denominated asset that the ECB can purchase.

      But I don’t really buy this. I think it is a fundamental misreading of the bond markets and the role of a central bank.

      I think he has internalized the concept that international capital markets set interest rates rather than central banks. He focuses on bonds since these are the instruments that he is exposed to and operates with; coming from the banking sector, bond defaults are cataclysmic whereas the zero-ing out of equity is not. Banks do not fund themselves with roughly equal proportions of bonds and equity as non-financial firms. They are highly leveraged, so by definition are more sensitive to bond prices.

      None of the above explanation is coherent in any model-specific sense, but neither is Trichet.

  3. “But it’s not just that money is more important than people; it’s that capital in the form of money (or at least closer to money) is more important than capital in the form of productive enterprises.”

    Right. It is not a capitalist viewpoint, it is an aristocratic viewpoint.

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