THE ECB Spring: Change in Tone with Strong and Long Term Commitment from the ECB

The main message from Mario Draghi at his press conference was the following “The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.”
Official interest rates could go lower if needed. This means refi rate could go lower but also deposits facilities rate which in that case would become negative. This possibility has not change the way Mario Draghi answered questions. He just said that everything was ready to manage this possibility. Negative interest rate on deposits facilities is something that has been accepted at the ECB.
This long-term commitment was taken unanimously. Draghi said that there were intense discussions on interest rate strategy and a possible decline. At the end the discussion ended with stability.

The three main reasons for this long-term commitment from the ECB are:

1 – An activity that is slow to recover: the ECB still considers that the risks are still on the downside due to a lack of demand, especially internally.
2 – Inflation rate is too low compared to the ECB target which is stable inflation slightly below 2%. Draghi failed to be totally convincing on an early return to the target
3 – Monetary indicators (including credits) do not increase. In May growth numbers were lower than in April

Financial turbulences following the Fed announcement on tapering are also a good reason for the ECB long term commitment. By indicating very low interest rate for a very long period of time, the ECB expects to maintain low the whole interest rates structure avoiding a possible contagion from the US. As European conditions were weak (condition 1,2 and 3) financial turbulences have been the trigger to this new ECB strategy.

Mario Draghi didn’t say how long could be the extended period. In May he announced that at least until July 2014 liquidity operations will be with full allotments. This means that at least until this period interest rates will remain low. I’m sure that they will remain low for a longer period.
It’s the first time that the ECB takes such a commitment. In the past Jean Claude Trichet didn’t want to take commitment beyond one month. Draghi now clearly wants to set expectations of all stakeholders in the economy showing more clearly and explicitly what he would do.
For players in the economy, households, entrepreneurs and investors, this is essential to be able to project into the future and be able to imagine investment plans. The Fed had implemented this communication long ago; it is unfortunate and damaging to the euro area that the ECB has taken so long to pursue this option

It also means that we cannot exclude that the ECB will maintain its very low rates beyond what could be done by the Fed on the U.S. interest rates. This may have an impact on the parity of the euro and thus restore some price competitiveness to European countries

In addition concerning the mechanisms leading to Banking Union and the European Stability Mechanism and its use in the bank recapitalization Draghi was reassuring simply stating the need to move quickly to implement the Single Supervisory Mechanism and a Single Resolution Mechanism. The discussions are not completed, however at this point because the dissociation between governments and the banking system still does not seem assured. This remains a concern as one risk of crisis, from banks to government, is not excluded by the commitment found between Euro Area members.

Conclusion

The extension of the commitments of the ECB is a major step because it allows a better view of the future. The ECB is committed in the long term because it considers that the current situation will not improve spontaneously, and that it is part of its contract to manage the risk in order to ease the recovery.
This is a major change in philosophy, a break with what was set up so far. In other words, the ECB finally assumes its role and the need for it to reduce the overall risk to see the economy go up.

Why haven’t they understood this before, while other central banks have explicitly taken this commitment a long ago? This will be the question for economists to think for a while (an extended period)

From the point of view of expectations that we may have, is a high probability now have a lower refi rate to 0.25% and a negative deposit facilities rate (-0.25%).

Listening to Draghi it seemed to me that his greatest fear was the lack of possible nominal tensions and that ultimately the risk of deflation is not completely eliminated. In other words, the absence of tension on the production system and the low banking dynamic (credit growth) could ultimately lead to an ambiguous change in price dynamics. It is the perception of risk that I had while listening to Draghi. And the ECB president does not want to take this kind of risk. That can explain the long term commitment