The Week In The Euro Zone : Draghinomics

From “never pre-committing” to “forward guidance” The European central bank (ECB) is living a kind of soft revolution under Mr Draghi’s presidency. After having introduced exceptional long-term refinancing operations (LTROs) and announced the Outright Monetary Transactions (OMT), the Bank decided to depart from its “never pre-committing” framework which characterized its rate decisions. At the July meeting the Governing Council adopted a “forward guidance” regarding its key policy rates, as other central banks do. Mr Draghi stressed that key policy rates will remain at present or lower levels “for an extended period of time”.

How extended is an “extended period of time”?
The “extended period of time” remains a vague sentence; however, Mr. Draghi said that inflation expectations, economic activity data and monetary developments, including credit growth rates, will be the ingredients of this forward guidance. Given that inflation, despite some volatility due mainly to base effects related to energy prices, will remain on a downward trend this year and next, that credit growth is unlikely to pick up any time soon and that the recovery will be very muted, interest rates are unlikely to be raised before the end of 2014 at least.

Very distant from exiting
The tightening of financial conditions in the eurozone, caused by the general market sell-off following the announced tapering of QE3 in the US, was among the main factors triggering the ECB reaction. This is a clear illustration of how different are the positions of the US and the eurozone in their business cycles. In the US, the Fed, supported by the strength of the recovery, could signal that the economy would need less support from monetary policy, should the recovery continue to gain momentum. Here, Mr. Draghi was forced to affirm that the ECB is far from exiting from its monetary policy accommodation. This is definitely downbeat for the euro, which has fallen against the dollar in reaction to Mr. Draghi’s speech.

Recent events suggest how tricky central banks’ communication is.Market overreaction might indeed provoke effects opposite to what central banks are trying to do. It is therefore warranted that any nonconventional policy comes out with a precise and credible exit strategy, fixed in advance. Otherwise uncertainty regarding the withdrawal of monetary stimulus might offset all the positive results achieved by unconventional policies. On this point the ECB is probably in a better position than the Fed. The strategy adopted by the ECB to cope with the crisis is based essentially on non-standard lending measures. The OMT has indeed been announced, but never activated, thanks to the ECB credibility. By contrast, the Fed undertook outright purchases of debt securities. Under the full allotment-fixed rate strategy, followed by the ECB in all its refinancing operations, commercial banks rather than the ECB determine the quantity of liquidity they need. Under this framework banks have been asking amounts of liquidity well above their needs as they were building buffers against negative shocks, given uncertainty and lack of confidence among credit institutions. Once that confidence is returned and banks’ balance sheets have strengthened, financial institutions will progressively reduce liquidity demand from the ECB. Consequently, the excess liquidity will decrease and the ECB’s balance sheet will begin to narrow automatically. In that sense the ECB has adopted a kind of nonconventional policy whose exit strategy is endogenous, at least to some extent, while the Fed has to announce when and how it intends to reduce its purchases of debt securities.

What actions going forwards?
Key policy rates were left unchanged at the July’s meeting. However, the Governing Council introduced a downward bias in its monetary policy stance. According to Mr Draghi, there was a wide discussion within the Council regarding the possibility to cut the refi rate, adding that 0.5% is not the lower bound for the refi rate. Declining inflation would give the ECB the room of maneuver it needs to embark on further actions. In addition, the Council remains extremely prudent regarding the recent improvement of confidence indicators. Although this was good news, confidence indicators just signal that the recession is close to an end, but they are far from signaling a solid and strengthening recovery. Credit is still falling at rapid pace in peripheral countries while it is barely expanding in core countries. Last but not least, recent political turmoil in Portugal might increase market uncertainty, and negative spill-over effects might affect financial conditions and confidence in other countries, undermining their recovery processes.

Should conditions deteriorate, or remain at this depressed level, the ECB could lower the refi rate further. It should be quite easy to reach an agreement on this point within the Council. A cut before the end of the quarter might not be ruled out. The ECB might also embark on new non-standard measures, such as negative interest rate on the deposit facility (DFR). A negative DFR might trigger banks to use the liquidity borrowed from the ECB for loan distributions or asset purchases rather than leaving it on the ECB’s books. As currently banks from core-countries have large excesses of reserves, this measure might increase capital inflows towards peripheral countries, easing significantly their funding conditions. However, given that this operation might trigger some negative effects, such as a reduction of bank profitability, or drastic reduction of excess liquidity, the ECB has fixed the bar relatively high to implement it. In addition, the cost of this operation risks to be unevenly supported from one country to the other as main users of the deposit facility are banks from core countries, mainly from Germany, Luxembourg and Finland, and this element might create some tensions within the Governing Council.

Hopefully the progress towards a banking union will strengthen confidence in the banking sector. A healthy banking sector is a precondition for healthy recovery, mainly in the eurozone where the private sector is highly dependent on banks as a source of external funding. Concrete progress and the fully implementation of the banking union could reduce the need of further unconventional measures from the ECB.

BY Clemente DE LUCIA