On Central Banks and German Economic Doctrines

It was another negative week for most of the precious metals. Only palladium managed to close higher compared to the week before.  Platinum recorded the smallest percentage loss with a decline of 0.6%. Usually, silver is more volatile than gold. However, this week, gold lost 2% while silver was fell only 1.6%. Looking at intra-day charts, it is easy to detect what drove the precious metals lower: central bank policy actions – actual and expected future ones.

Already last week, we wrote that the markets would speculate on a further ECB rate cut after the preliminary consumer price inflation fell to only 0.7% in October. However, at the beginning of this week, the consensus moved towards expecting a rate cut at a later date. But the ECB taught the markets again the lesson that one should not fight against the central banks. It also humiliated the Royal Swedish Academy, which rewarded this year’s Noble laureate to Eugene F. Fama for his theory that financial markets were dominated by rational expectations and information efficiency. The ECB did not hesitate and reacted quickly by cutting the key refinancing rate by another 25 basis points to a mere 0.25%. After the release of the ECB rate cut, the euro dropped against the US dollar by almost 2 cents to 1.33 within 45 minutes. This dragged also the precious metals lower. If Fama’s theory would be correct than the markets should have already priced in the rate cut and should not have reacted so strongly.

The ECB council decision was not unanimous. It has been reported that opposition came mainly from the Northern members, led by the German Bundesbank president Weidmann. The ECB has also been criticized for the rate cut by German economists and institutions. The head of the savings bank association, an economist, stated that the ECB would expropriate the Germans. Representatives of life insurance companies or pension fund managers blamed the ECB for punishing savers. These statements are pure nonsense. First, expropriation means that some property is taken away by the government. However, after the ECB rate cut, savers possess the same amount of bank deposits, which they would hold in the case rates remained unchanged. It is not the duty of the ECB to keep interest rates at such a level that the thrifty Germans earn a positive return on their short-term time deposits.

The ECB can only set short-term interest rates and the duty of the ECB is to maintain price stability, which implies to prevent both, inflation as well as deflation. Thus, the ECB acted according to its mandate. German savers still have the opportunity to switch into other assets, which yield a positive return. That the ECB had to cut rates to prevent a deflation in the Eurozone is a consequence of the German economic policy, which impost austerity measures in the eurozone. And it is also related to another development Germany had been criticized for by the US Treasury, the IMF and the EU, the huge surplus of the German current account, which reached a new record high in September.

Fiscal austerity in many Eurozone countries led to a decline of domestic demand and corresponding pressure on consumer prices. The German export surplus reflects also that Germany’s domestic demand is too small as Germans save more than the companies invest. This is a simple economic accounting relationship, which is not understood by the German politicians and business leaders. Defending or even extending the export surplus implies also that other Eurozone countries will struggle further to increase economic activity by exporting more to Europe’s biggest economy. But as long as total demand in many countries remains sluggish and pressure on consumer prices persist, the ECB policy will have to remain expansionary. This should have a dampening impact on the exchange rate of the euro against other major currencies.

The second push lower for the precious metals was not triggered by actual central bank policy action, but by expectations about future measures. The US labor market report came in stronger than the consensus among Wall Street economists predicted. The number of new jobs created at 204K exceeded the consensus by 83K. Also the preceding two months numbers have been revised higher by a total of 60K additional jobs. Now the markets fear that the FOMC might decide to taper the bond purchases already at the next meeting in December instead of in Q1 next year. Thus, the US bond market sold off and the US dollar strengthened against major currencies, both developments were negative for the precious metals.

However, the market overlooks again that the FOMC is not only focusing on the labor market report. Furthermore, one swallow does not make a summer. The previous reports were weaker than expected. Thus, the FOMC would like to see some confirmation that the labor market improves at a sustainable and sufficient pace. Other economic data was mixed. The ISM reports came in stronger than expected but activity indices from some regional Federal Reserve Banks and consumer sentiment were below consensus forecasts. Therefore, the FOMC is likely to postpone tapering beyond the December meeting.

But tapering is only a question of time. Thus, while the Fed is expected to become less expansionary, the ECB might have to take further monetary measures to prevent a deflation in the Eurozone despite consumer price inflation in some member countries might get close to the target. However, embarking on quantitative easing is more difficult for the ECB than it was for other central banks like the Fed or the Bank of England. While the EU treaties allow the ECB to buy government bonds in the secondary markets, the problem would be which bonds should be bought. Buying government bonds from all countries does not make much sense. If the ECB would buy government bonds of those countries where the risk of deflation is the highest, than complaints would come from Germany and other Northern countries. A difficult task for the council to select the proper instruments. But as the ECB demonstrated, the council is ready to act in time and it would ease monetary policy even further to fulfil its mandate. The implication for the precious metals is that they might remain under pressure by a firmer US dollar.