ECB policy: Analysis of Mario Draghi’s speech

2012-08-02

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The August 2 European Central Bank governing council meeting is now over. Market expectations were kept high in anticipation of an intervention of the ECB in the secondary markets, or perhaps of some other unconventional and awe-inspiring monetary policy to decisively lower the borrowing costs of Spain and Italy. In the press conference following this much anticipated meeting Mr Draghi, the ECB president, reinstated his institution’s firm devotion to operate within its mandate, which strictly prohibits it from directly buying government bonds. The ECB president touched upon several issues, hinting to possible actions to be taken in the upcoming days or weeks, without however making any explicit reference to the way this will or might be done.

To better appreciate his speech, it is helpful to put under scrutiny each of his key points, in order to single out his core message and perhaps speculate over the most possible scenaria henceforth (all quotes are taken from Mr Draghi’s introductory statement – any emphasis in the quotes is mine).

Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged, following the decrease of 25 basis points in July. As we said a month ago, inflation should decline further in the course of 2012 and be below 2% again in 2013. Consistent with this picture, the underlying pace of monetary expansion remains subdued. Inflation expectations for the euro area economy continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term.

Given that the benchmark rates were already reduced a month ago, it would be premature to proceed into another reduction. Inflation in consumer goods and wages will indeed remain low for quite some time. The primary reason for that is that liquidity has not been reaching out to the real economy, to increase money in circulation. Instead whatever monetary expansion has taken place thus far through the various channels of the Eurosystem, has been directed into state coffers and quasi-bankrupt banks, with the two-fold aim of first keeping Spanish and Italian average bond yields at relatively affordable rates and second of sustaining the operations of many of the ailing, under-capitalized European banks. As such, new money does not flow into consumption to exert pressure on the prices of consumer goods and on nominal wages (this does not mean that there is no inflation, but only that it does not spill over to the real economy – the way we now measure inflation is inherently flawed and I will expand on this in a future post).

The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.

I have written about this on several occasions, but allow me to repeat myself in short. As the institutional order of the euro zone currently stands, there remains great uncertainty about the integrity of the euro and in particular about the future membership of hardly-pressed governments in the single currency. Despite the pompous remarks of EU officials and country leaders, which though they might sound determined, are not consistent with their later unambitious and often self-contradicting policies and actions. In conjunction to this uncertainty, banks are under-capitalized and instead of consolidating their balance sheets, they may improve their position by getting hold of top quality collateral (core country sovereign bonds, e.g. Germany). In other words banks have strong incentives, to (i) avoid buying peripheral country bonds in fear of exits and consequent “haircuts”, (ii) prefer to buy core country bonds to increase their capital buffers.

As we have witnessed over the last months much of the increased Eurosystem liquidity was channeled directly back to the perceived safe havens instead of going to the countries that needed it the most, largely due to fear of continuing deterioration in the periphery. This is reflected in the fact that while Spanish and Italian bonds remained on the rise despite the massive €1 trillion LTRO programme, yields in core countries dropped to near-zero or even negative rates.

Within this context, it must be stressed that an increase in the money supply will, ceteris paribus, most probably have a negligible impact in arresting the crisis. In fact it might well produce the opposite effect as it will invigorate this divergence in interest rate spreads. The harsh reality is that thoroughgoing reforms in member-states and in the very institutional order of the Euro area may only reverse this indeed unpleasant situation.

In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination.

This is perfectly in line with my comment above, that the institutional order of the euro zone requires several additions and reforms, in parallel to all efforts that take place at the member-state level. There need to be steps towards a banking union, a fiscal union and an eventual political union of some sort, together with all other mechanisms and tools for collective action and responsibility, which will make it evident that the euro in particular and European integration in general are indeed irreversible. Only concrete plans and steps forward will address the confidence crisis that has gripped the euro. This task falls upon the shoulders of politicians, not on the ECB alone.

As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.

This is a clear-cut statement that the ECB is not willing to, or not mandated to, replace the role of elected governments. What Mr. Draghi says is that any urgent programme to contain spreads, must come from the EFSF/ESM, and only after governments have all agreed to do so. In effect this suggests that any “firewall” will not be in place without tough bargaining and in quite some time for now. After all the compatibility of the ESM with the German constitution will be determined in September at the country’s constitutional court; so there can practically be no activation of this mechanism earlier. Perhaps if conditions reach a critical point before the ESM is activated, then the EFSF can be used for some surgical interventions; but for nothing more than that, given that its funding capacity it ancillary relative to the magnitudes of Spain and Italy combined. Notice also that even this will only happen provided there is “strict and effective conditionality in line with the established guidelines”, which in my understanding means that any government, Spain first, Italy second, will effectively have to enter a bailout programme similar to those in Greece, Ireland and Portugal, so that the troika may impose on them strict conditions for austerity and reforms. In other words there will be strings attached to any funds that may be disbursed; so do not expect any easy money, for there is none.

The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.

By open market operations Mr Draghi is in fact implying that the ECB may at any time, without any political bargaining, proceed to the purchase of assets with short term maturities, so as to effectively place a ceiling on short term interest rates. In effect the ECB considers such intervention as part of its standard operations in the money markets and is to be seen more as a programme that will address only the shorter part of the yield curve, excluding therefore 2year, 3year, 5year and 10year bonds which will remain open to the fluctuations of the markets. The underlying principle of this statement is that the ECB cannot influence long-term interest rates, which to be fair is perfectly in line with the institutional flaws mentioned above. The reason is that investors will not buy such long-term bonds when the very existence of the euro or of the membership of certain countries in it, remains highly uncertain in such a time horizon. Lastly mention is made to unconventional monetary policy measures, which will however require some time to be worked out in detail, given that the committees of the ECB have not devised a coherent framework of policy yet. My suspicion on this part is that they are laboring towards a strategy that will leverage the ESM once/if it gets a banking license, or at least some set of measures that will produce similar effects, so as to increase the funding power of central funds and mechanisms.

For the rest of his statement, Mr Draghi offers some indicators of the broader economy, which however bear little significance to the way he and his institution will operate in the coming days and weeks (at least relative to the issues mentioned above).

To sum up, the ECB will not step outside its mandate and will wait for governments to ratify the ESM and to allow it, together with the EFSF to intervene in the secondary markets, under “special conditions”. However it is readily apparent that the ECB can at any time engage in open market operations to buy assets with short term maturities in an effort to influence the shorter part of the yield curve, effectively placing an upper limit on short term borrowing costs. In the meantime the committees of the ECB will design the appropriate modalities for non-standard monetary policy measures for the weeks or months ahead; which might suggest that they will work out a plan to leverage the ESM once it is in place and after it has received a banking license.

Finally the overall stance of the ECB has made it clear that any funds that may be distributed to Spain and Italy will only come with strings attached. If these countries are unable to draw money from the markets, due to soaring interest rates, then they will have to enter a bailout programme similar to those in Greece, Ireland and Portugal that will allow the EU (and the core countries in particular) to push for austerity and reforms. Given all of the above, it is clear that Mr Draghi touched upon several issues and offered hints on possible actions, but he did nothing to clear some of the lacunae in the ECB’s plans. In fact it might be said that he only managed to obfuscate and hide any plans he and his institution may have. Ultimately it seems that much will depend on the reaction of investors to these latest news. If markets fall into disarray in fear of greater downward risks then it seems clear to me that the ECB will engage in open market operations, at least until the ESM is ratified and put into use, to buy government bonds from the secondary markets. The political reaction of Spain and Italy must also be seen in this context, as either a contributing factor to market unrest or as an effect of it.

We still have a long way to go before the euro zone escapes from the danger of breaking up. Decisions come at an excruciatingly slow pace due to the complexity of the decision-making process of the EU and its overall institutional design. Solutions are largely dependent on the audacity and open-mindedness of policy-makers to make the two necessary compromises for proceeding forward: (1) the core countries to accept making fiscal transfers to the periphery, (2) the peripheral countries to accept stricter rules and partial loss of sovereignty.

If these two conditions are met, which is still highly uncertain, then the euro zone will move towards its federalization and the ECB will gradually have a role reminiscent of the Fed or other major central banks, since for the time being it still operates within a sui generis political environment that greatly hinders any effort to address the crisis effectively. Without the perhaps politically costly steps towards further integration, there will be no credible solution to a crisis, which ultimately is about politics not economics.

Picture Credit: Wikipedia