The latest data show the slow deposit runs on Irish and Spanish banking institutions coming to an end. However, YOY growth in bank credit in negative in all of the PIIGS — Italy having recently succumbed to this condition. These data are consistent with the broad story: the financial system has stabilised in Europe, but a deep recession continues in the periphery. The recession in Spain, at least, is so bad that an improvement in its debt metrics cannot be taken for granted even as austerity continues.

Some commentators suggest that there could be another episode in the European crisis this year. I am sceptical of that — or, at least, nuanced. The European crisis could only ever have got as bad as the ECB allowed. With the LTRO in December 2011, the ECB gave us a sense of where its pain threshold was; in the summer of 2012, the threshold having been hit again, it acted again, confirming both the existence of the threshold and its approximate level. It acted in a different and unpredictable way the second time, and a certain amount of political manoeuvring by Mr. Draghi was involved, but the essential point remains the same: the crisis could always be headed off by the ECB, and the ECB would not allow a collapse.

What does this mean for 2013? In 2012, although Spain was much in the headlines, I do not think that is was the main causative factor for the market declines around the middle of the year. The immediate Spanish problem was a banking problem; it was clearly soluble, and the framework for a solution was pretty clear. The real problem in 2012 was Greece, and it was political: revulsion of a national population against austerity. The EU has a standard response to democracy — if you get the wrong answer, ask again — that worked well in 2012. However, it is not guaranteed to work, and that means that a similar situation in Greece or elsewhere could cause another European-driven risk-off phase in 2013.

Some of the news reports said that the equity market rally had stalled on account of fears about the debt ceiling. If you look at a chart, you will notice that this has been a one-day affair. I am not sure that the market is worried about the debt ceiling yet. Google Trends shows that searches for “debt ceiling” spiked at the start of January and have been declining since then; they are still a long way below their peak in mid 2011. Perhaps the market is confident that an agreement will be reached — realising, as I argued last week, that the Republicans have a weak hand. Or perhaps it is just the general truth that the market does not care about things until it does.

Italian polls have showed something of an advance for Mr. Berlusconi, but sane parties are apparently still in the lead. EMG has the following numbers for the three coalitions: Berlusconi 27.9%, Bersani 37.4%, Monti 14.8%. Bersani has already made an overture to Monti.

Yesterday I did some thinking about the effect of the change in the Fed’s forward-guidance language from being time-based to being based on specified economic conditions. I constructed a simple model that predicted that the change ought to be a moderate tightening of monetary conditions — a prediction that accorded well with the steepening of the Fed Funds futures curve in the week that followed the change. The Fed has attempted to remove a “cliff” of its own, the one that would arise when forward guidance was altered, presumably in fear of the kind of market disruption that followed its first interest-rate hike of 1994 or the the of QE2 in 2011. But by tying its forward guidance to economic conditions, the effect will be 1. that the market will have to guess at the Fed’s overall assessment of the economic outlook, which was previously implicit in the forward guidance and 2. that as the economic outlook improves, the market will assign a growing probability to future increases in interest rates without time-based forward guidance to keep that probability in check. The result of these two effect will be higher interest rates today, and rising interest rates if the economic outlook improves. These factors will work against recovery. Monetary policy is still very loose, but I think that, with its new forward guidance, the Fed inadvertently tightened at the margin in December.

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