Draghi disappoints

December 6, 2015


 
There was a big build up of expectations before the meeting of the European Central Bank council last Thursday that a big, or at least significant, program of further monetary stimulation would be announced. The eurozone has been bumping along in a more or less depressed state since the crisis of 2010 (see my previous post) and with many signs that global growth is slowing there are worries that the eurozone is vulnerable to any slow down in global trade. With unemployment so high and growth so low the eurozone clearly needs some sort of economic stimulation package and, with the single currency regulatory and treaty framework precluding any substantial fiscal stimulation, by default the ECB is the only body now capable of delivering an expansionist economic program.

On November 20th the Financial Times had reported “Mario Draghi has dropped his clearest hint yet that the European Central Bank is about to inject more monetary stimulus into the eurozone economy, brushing aside staunch opposition from Germany’s powerful Bundesbank. The ECB president said yesterday that ECB policymakers would ‘do what we must to raise inflation as quickly as possible’. The remark echoed a promise Mr Draghi made during the region’s debt crisis in 2012 to do ‘whatever it takes’ to save the single currency.”

What was actually announced turned out to be very underwhelming.

The ECB will cut the interest rate on overnight bank deposits from -0.2% to -0.3%, with effect from 9 December 2015, extend the monthly €60bn quantitative easing programme to run until the end of March 2017, and extend the scope of QE bond purchase program to include municipal bonds. This amounted to a painfully weak stimulus package. Markets had expected a 25 percent increase in monthly asset purchases and possibly even a deeper rate cut. More radical options that appeared to be under discussion included the purchase of corporate debt or a split deposit rate that would punish banks parking too much cash with the central bank.

What seems to have happened last week was that the hints by the ECB President Mario Draghi ahead of last Thursday’s ECB rate meeting that the euro zone may need another big injection of money backfired when the financially conservative block on the ECB governing council, led by the German Bundesbank, succeeded in preventing any major new financial expansion package being agreed. Draghi and his chief economist Peter Praet stoked expectations with dovish speeches in the weeks before the meeting but the ECB’s Governing Council concluded that markets needed to be disappointed this time because the economic outlook has improved and new inflation forecasts were not as bad as feared. Note that the concerns about the current conditions in the eurozone are now all about how low inflation is and the continuing deflation.

Reuters quoted one source with direct knowledge of the situation interpreted Draghi’s public stance ahead of the meeting as trying to pressure the Governing Council to take bigger action. “Draghi raised expectations too high, on purpose, and attempted to paint the Governing Council into a corner,” the Reuters source reported. “This was problematic and he was criticised for this by several governors in private.” Unlike last year, when opponents of quantitative easing made their stance public before the decision, the ECB Council hawks mostly worked behind the scenes. Opponents of Draghi worked to curtail proposals coming out of the ECB’s committees that prepared the decisions, ensuring that some of the more radical measures expected by market players never made it onto the table.

What was in the end adopted was the set of options that could gather a comfortable majority within the ECB governing council where it appears the hawks and conservatives hold a majority. The smaller than expected move amounted to a political defeat for Draghi, who has established a track record for promising and delivering big, as he did with his July 2012 pledge to “do whatever it takes” to preserve the euro and pushing through bigger than expected QE earlier this year. By talking up expectations and then delivering so little the ECB has now managed to confuse markets and the public. From now on, markets will treat hints dropped by ECB president Mario Draghi and some of his colleagues with much more scepticism than before.

Deutsche Bank chief economist David Folkerts-Landau had this to say (my emphasis):

Policy easing fell short of very high market expectations.

Looking beyond the market disappointment, the fact remains that the ECB has eased monetary policy further. I can understand why from an economic viewpoint – the ECB is hoping to offset external risks to inflation and growth by weakening the euro and boosting domestic demand.

Yet I remain disheartened that seven years on since the financial crisis the eurozone cannot stand on its own feet without massive central bank intervention and guarantees.

Monetary policy is compensating for a lack of national government progress on necessary structural reforms. Mario Draghi’s comment that the ECB will do “whatever it takes” has surely contributed to this situation. I strongly believe that this is unsustainable.

Claus Vistesen at Pantheon Macroeconomics had this to say (my emphasis):

“The announced measures will ease further the already very loose stance of monetary policy, but the ECB’s actions were much less aggressive than markets expected.

We are inclined to think Mr Draghi and the doves were reined in slightly by the hawks today, or simply underestimated the market’s expectations. We are particularly surprised that the ECB cut its inflation projections—even if only marginally—and then opted to deliver a response guaranteed to trigger market moves opposite to their intentions

The announced measures will ease further the already very loose stance of monetary policy, but the ECB’s actions were much less aggressive than markets expected.

We are inclined to think Mr Draghi and the doves were reined in slightly by the hawks today, or simply underestimated the market’s expectations. We are particularly surprised that the ECB cut its inflation projections—even if only marginally—and then opted to deliver a response guaranteed to trigger market moves opposite to their intentions.

When the financial crisis struck in 2008 the central banks, particularly the US Federal Reserve and the Bank of England, acted quickly (and correctly) to prop up a collapsing banking system and then followed up by the innovative use of a massive central bank bond purchasing program (Quantitive Easing) to try to inject some liquidity into frozen credit markets to help prevent the recession from becoming too deep. The ECB took much longer to respond to the crisis and its QE program took years to get underway, was too late and too small, and hardly made up for the mistakes the ECB made when, post the 2010 eurozone crisis, it insanely decided to tighten rather than loosen monetary conditions thus turning the eurozone recession into a protracted double dip depression. The problem now is that after years of extraordinary and unprecedented monetary stimulus, including reducing interest rates to almost zero, the recovery in the developed economies have not been very strong. The eurozone, the world’s largest economic block, has never really recovered from the crash and appears to have settled into a permanently depressed state. Meanwhile the global economic, trade and financial imbalances that were the root causes of the 2008 financial crisis were not rectified back then and are only now just starting to slowly unwind. The rectification of these structural imbalances, especially in China, will take quite some time to unfold and will result in a depressed rate of global growth in the years ahead. A reduction in global growth will make things harder for the developed economies and could push the eurozone back into crisis. Because of the eurozone treaty restrictions on public budget deficits the only remaining mechanism for delivering pro-growth economic policies in the eurozone is the ECB and on the basis of last week’s performance it is simply not up to the job.


 
Here is a short video that explains what Quantative Easing is

 

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