The ECB and the riddle of the markets

Probably the biggest surprise of 2013 so far has been the dogged optimism of the financial markets. When the economic news is good, share prices rise. But when the news is bad, they often seem to go up as well.

It's a puzzle for economists everywhere, and there's no better example than this week's hotly anticipated European Central Bank meeting.

"Everyone is so excited about whether the ECB will cut rates," Michala Marcussen, head of global economics for Societe Generale, told me. "You have to wonder why - when everyone also seems to agree that a rate cut will not do much to help the real economy."

The answer to the riddle is that it might not help the real economy, but it's a fair bet that it will help equities. In fact, that is probably why the markets have been rising on bad economic news - because, other things equal, bad news suggests that central banks will keep the markets bathed in super-cheap liquidity for that much longer.

But, you might well ask, doesn't the real economy eventually have to start to reward all that market optimism? Don't European companies eventually have to start delivering the revenue and earnings growth built into all those rising share prices?

That is the big question hanging over the ECB meeting today and over all European policymakers, waiting for any sign that the depressed eurozone economies are on the mend.

Politicians and officials have generally been happy to have the market run ahead of the real economy in the past six months, because they felt that the more positive mood would turn into a self-fulfilling prophesy. Higher confidence would beget lower borrowing costs, which would beget rising lending to companies, which would finally lead to some growth.

Has that happened? Well, the first part of the chain has. Borrowing costs in the distressed economies have fallen for firms and governments.

But not nearly as much as the markets have risen. And that improvement in credit conditions has yet to offset the deflationary impact of continued fiscal austerity, which - if anything - will be greater in 2013 than it was in 2012 in countries such as Spain and Portugal.

Last week, the average unemployment rate for the eurozone as a whole hit 12.1%. It's less than half that figure in Germany - just 5.4%. While in Spain, the rate of joblessness is now pushing 27% - with youth unemployment much higher than that.

Mario Draghi has again made clear in recent speeches that fixing the structural economic problems of Spain and the rest cannot be the job of the ECB. But he has also said the ECB will continue to fight the balkanisation of European finance.

Image copyright ECB

These charts from a recent speech by ECB Vice-President Vitor Constancio show that, although borrowing costs have fallen in much of the periphery when it comes to households and companies, there's still a wide gap between German interest rates and rates at the periphery.

In the jargon, the "transmission mechanism" for the ECB's monetary policy is still impaired, and credit is still crunched in the countries that need it most. All of which may help to explain why market expectations surrounding this ECB meeting have been so high - and expectations among economists are so low.