Markets demand forceful action from central bank which has been failed by politicians
Frederik Ducrozet
Ever since Mario Draghi took office 8 years ago, he has dealt with the consequences of other policymakers’ mistakes, incompetence or inertia © Reuters
As markets seem prepared to call the European Central Bank’s bluff, we are left with fear and hope — that Mario Draghi and his successor will rise to the challenge.
Story of his life, as they say. Ever since the ECB president took office eight years ago, he has dealt with the consequences of other policymakers’ mistakes, incompetence or inertia. As he nears the end of his term in October, we have lost count of the number of times Mr Draghi has been under pressure to act, having already done the right thing.
On his first day in office in November 2011, Mr Draghi cut interest rates in response to his predecessor’s premature tightening of monetary policy. He then followed up with the first series of long-term refinancing operations (LTRO) for banks, which proved decisive in stemming the widening in sovereign debt spreads. When the euro’s existential crisis later led to a rapid rise in the so-called redenomination term premium (a measure of euro break-up risk), Mr Draghi responded with the three most powerful words a central banker has ever said: that he was ready to do “whatever it takes”, within his mandate, to preserve the single currency.
When front-loaded, synchronised fiscal austerity led to a double-dip recession, the ECB eased again, with forward guidance in July 2013 and negative rates in June 2014. When financial fragmentation threatened the transmission of monetary policy, the ECB doubled down on credit easing, including a “targeted” LTRO. Finally, when a global slowdown and a collapse in oil prices led to deflation fears, the answer was bond purchases — quantitative easing — culminating in over €2.5tn in asset purchases by the end of 2018.
It is not the failure of its monetary stimulus that has forced the ECB to ease again and again over the past eight years. Rather, national governments continued making promises they never delivered on, while failing to move beyond their differences to make the monetary union more resilient and efficient. It is the failure of politicians to take over that has left the ECB on the hook.
Faced with “pervasive uncertainty” and persistently low inflation, the ECB stands ready to act again today. Market-based inflation expectations are falling like a stone as ECB members meet for their annual conference in Sintra this week. Crucially, Mr Draghi has ruled out nothing for the June meeting, meaning rate cuts and new asset purchases are all on the table.
For markets, the devil will be in the details of any new stimulus. Cutting rates could be the path of least resistance, especially if aggressive monetary easing from the US leads to a stronger euro and an unwarranted tightening of financial conditions in Europe. In that case, the broader market reaction would largely depend on the implementation of mitigation measures for banks, as negative policy rates get closer to levels where their counterproductive effects outweigh the benefits. An even bolder move would include a cut in the ECB’s main refinancing rate, currently set at zero per cent.
Forward guidance is likely to be adjusted again, whether the ECB cuts rates or not. A proposal from Finnish central bank chief Olli Rehn to link the timing of the first rate rise to a sustained adjustment in (core) inflation using state-contingent forward guidance may be appealing to the Governing Council, eventually.
But, in a more adverse scenario, the ECB would have to resume bond purchases to address the risk of de-anchoring inflation expectations. It could do so by either adjusting limits on purchases to 33 per cent of member countries’ debt, or by tilting debt purchases toward corporates, supranational entities and/or the most indebted governments. In the former case, German Bund yields could fall even further into negative territory; in the latter, Bund yields could jump back above zero and the yield curve would steepen.
One option could be for the ECB to engineer a form of “insurance QE” in a similar spirit as potential insurance rate cuts from the Fed. That could take the form of a front-loaded programme with no predefined quantity of monthly purchases, but a total envelope to be spread over time with greater flexibility, depending on macro and market conditions.
The bigger picture boils down to the ECB’s credibility — its greatest asset under Mr Draghi’s presidency. If conditions deteriorate sharply, markets will demand another grand statement of intent. The hope could be to talk the QE talk without walking the walk, given all the institutional, political and technical hurdles embedded in a new QE programme. Inflation expectations, equity markets and the euro will rise if, and only if, the policy response proves credible.
Credibility inevitably raises the question of Mr Draghi’s successor. The biggest challenge he or she will face may not be to ease or to normalise monetary policy, but to maintain trust in the euro’s most important institution.
Frederik Ducrozet is a global strategist with Pictet Wealth Management, based in Geneva
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