Something that many observers miss about the Eurozone crisis is that by doing nothing the ECB is doing something: it is passively tightening monetary policy. Total current Euro spending is falling, either through a endogenous fall in the money supply or through a decrease in velocity, and the ECB is failing to respond to it. The impact of passive tightening is no different than that of an overt tightening of monetary policy. Currently it is tearing the Eurozone apart.
Michael Darda sees this passive tightening by the ECB and is not impressed:
European markets quickly ran out of steam today on news of a Spanish bank recapitalization over the weekend. Part of this may be due to the fact that equity markets already discounted the news last week. Moreover, the ECB took a pass on a relatively costless (in our view) opportunity to surprise to the upside with even symbolic monetary stimulus (rate cut, anyone?). Given the ongoing pressure on Spanish and Italian sovereign debt markets—and the correspondingly level of regional inflation expectations—the Spanish bank recapitalization is highly unlikely to be enough to set the eurozone on a more robust growth trajectory. Indeed, we do not believe additional EFSF/ESM measures will be effective unless they are coupled with a much more accommodative ECB monetary policy (i.e., one that provides for faster euro-area nominal GDP growth). The key here is for the ECB to manage expectations properly. Closed-ended, ad hoc actions that are limited in scope are not likely to bear fruit, as increases in base money get absorbed by falling base velocity. A more open-ended and aggressive commitment to reflationary policies, however, would likely require the ECB to do less with its balance sheet, as market forces would help the ECB ease. Although we believe ECB President Mario Draghi got off to a good start, we are not encouraged by recent statements and the lack of follow-through at a critical juncture for the eurozone.
Passive tightening is fashionable these days. It is being done of both sides of the Atlantic.
Update: Jim Pethokoukis agrees with Michael Darda.
This post originally appeared at Macro and Other Market Musings and is posted with permission.