“Whatever it takes” Five years later

Five years ago, Mario Draghi made remarks in London that have changed the world.
When he spoke in London on July the 26th 2012, the Euro area was in its deepest recession since WWII* and two important countries, Italy and Spain, were following a non sustainable trajectory that can be described as a deep recession with high real interest rates.

These problems came from the European decision to follow austerity policies. These latter dramatically reduced domestic demand but without having a strong impact on public finance. So the main question for Italy and Spain was the date of their exit from the Euro area; not if but when.
An exit from these two countries would have led to a collapse of the Eurozone. This would have destabilised the world economy.

Five years ago, in London, Mario Draghi did three things

First he said that the Euro Area was a political construction. It was the result of countries' will to live together. It has worked. The area has been in peace since WWII. This is the most important point for Europe. The euro currency is just a technical commitment. An important one but not more than that.

The second point is the following: if the currency is just a technical mean to improve the way the Euro area political framework works then it has to continue. The collapse of the Eurozone (after an exit from Italy or Spain or another country) would have been a source of political instability in Europe and probably the end of most European institutions.
The role of the ECB was to save the Eurozone by avoiding a collapse of its currency.
The famous sentence "whatever it takes" (the whole sentence is "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.") explains this new mission.
After this sentence the ECB became the lender of last resort that a monetary construction needs. Until this moment the central bank had never played this role. It's a fracture in the European institutional framework.
In a situation where governments didn't know what to do, the ECB became the leader under the auspice of Mario Draghi.

The third point came few days later at the ECB monetary policy meeting with the creation of the OMT which allows the ECB to buy assets (public debt) mainly in Italy and Spain. This was enough to reduce tensions on these two countries. Later in 2012 and after in 2013 the interest rate spreads with Germany decreased dramatically. This was the end of the main divergence within the Euro area.

The ECB has been a game changer by avoiding the collapse of the European construction. Since then, economic policy leader is the central bank under the impulse of Mario Draghi. Progressively the fiscal policy has converged to a neutral stance. The Eurozone economic policy is now done in Frankfurt more than in Brussels.
The QE strategy was consistent with this new ECB framework. It had to create the necessary impulse that would provoke the recovery. It has worked with all the instruments used in this non orthodox monetary
The European Central Bank has been the channel for a smooth adjustment in the most important financial crisis since WWII.
Its job is now almost over as the growth recovery is now strong. It just have to keep its accommodative monetary policy in order to ease the needed political adjustment. The next step of the Eurozone institutional construction is political. It's time for government to take the relay.
We will forget a lot of ECB presidents, past and future, but Mario Draghi will remain as the one who save the European construction.

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* The Euro Area has started in January 1999, but if we look at the economic situation of constituant countries since WWII none of them has had such a recession.

The ECB hasn’t changed its mind on its monetary policy

The ECB remains committed for an extended period to a very accommodative monetary policy stance.
There is no strategic change in the ECB economic diagnosis on the Euro Area. The recovery is getting strength and risks are now balanced. But the inflation rate is still way below the ECB target at below but close to 2%. On this specific point the ECB explains that the low oil price is an explanation but it is not sufficient as the core inflation rate is still close to 1%. Draghi said the inflation should stay close to the current level (1.3%) in coming months. Therefore no convergence to the target is expected by the European Central Bank in a foreseeable future.
In other words, the recovery is strong for the real economy side but still very limited on the nominal side. As far as the inflation rate remains low, the monetary policy will remain accommodative; the ECB will continue to purchase large amount of assets as long as long term inflation expectations do not converge to the target. It could change its mind also in case of inflation surge in coming months but that's not the ECB perception of its profile.

I do not perceive in the ECB statement a change in tone or in the way the monetary policy will change in the future. Those who thought that there was a new message at the ECB seminar in Sintra were wrong.
The asset purchases program will be discussed next autumn (probably in September) as the current one is supposed to end in next December if long term inflation expectations converge to 2% or if the inflation rate is close to the target. The amount which is currently at Eur 60bn per month will probably be lowered in 2018 as the recovery is strong but we won't have a termination date as long as the inflation rate at 2% is not expected rapidly. We can expect 30 or 40 bn per month after December 2017.
The ECB has not to hurry in changing its monetary policy stance as its impact is asymmetric. Changing it too quickly is taking a negative risk on the recovery – that's not what is wished by the ECB for the Euro area economy. The central bank can wait for a higher inflation rate before changing its mind.
The ECB target must be a stronger and more autonomous growth momentum supported by the domestic private demand. For that, an accommodative monetary policy for an extended period is still the recipe.

It’s all up in the air with central banks

Have the central banks become sources of confusion for investors? We may well think so after comments by the president of the European Central Bank Mario Draghi, and the governor of the Bank of England Mark Carney. At the ECB conference held during the week of June 26, both made comments suggesting a swift change in the two institutions’ policies.

Mario Draghi referred to above trend growth in the euro area to imply that the ECB should factor this in when deciding on its strategy. He stated that “deflationary forces have been replaced by reflationary ones”, and listeners instantly took this as a sign of the end to monetary accommodation with the beginnings of tapering at a specified date. This prompted a surge in the euro against the dollar and a swift rise in long rates. The ECB indicated that this reaction was too forceful and that investors had over-interpreted the president’s comments.

Meanwhile at the Bank of England, Mark Carney hinted at an interest rate rise by the central bank, having displayed quite a different stance just a few days before. At the latest Monetary Policy Committee meeting, the Canadian governor of the Bank of England had left the policy stance unchanged, leading to a rise for sterling and the 10-year interest rate. Continue reading

The Bank of England dilemma

Interesting time in the UK as the Bank of England is facing an important arbitrage. There are potentially two types of shocks in the UK.
One is associated with the consequence of the Brexit on the growth momentum. And the other reflects higher inflation rate (above the 2% target).
The BoE meeting this morning has shown that MPC members may have very different views on monetary policy drivers. At this meeting the vote was 5 for rate stability and 3 for higher rates.
Just a reminder: the BoE has reduced its main rate to 0.25% last July just after the referendum on Brexit in order to accommodate the possible negative risk associated with the referendum result.

Two graphs on recent data can illustrate the MPC dilemma.  Continue reading

Fed: The announced normalization

The Fed main interest rate was increased by 25bp at the June meeting of the FOMC. It will now be in the corridor [1; 1.25%]. This is the fourth hike since December 2015 (start of the tightening cycle).
The impact of this monetary policy change has been very limited. The Fed’s communication strategy is to clearly say in advance what it will do. The Fed doesn’t want to create surprises to investors. Therefore investors can adapt their expectations and their portfolios to the new monetary policy stance. The impact of the measure when it is announced is null.
This is interesting notably on emerging markets. In the past, the Fed’s tightening cycle had a strong impact on them as capital flows were back to the US at the expense of emerging countries. Investors were surprised by the Fed’s move. That’s what economists call a sudden stop. Here, no one is surprised so there are no reversal in flows and emerging markets remain strong.

The Fed considers that the economy is now close to full employment (employment rate is 4.3%) and the inflation is close to its 2% target. Therefore it can be rational to increase rates. But as mentioned earlier, the Fed doesn’t want to create too much volatility and to create a persistent shock on the economy. That’s why its measures are announced loudly in advance.  Continue reading

What could make the ECB change its strategy?

This is the question we could well raise the day after Mario Draghi’s press conference that followed the monetary policy meeting.

The President of the ECB was emphatic in convincing his audience and the entire investment community that there is no question of the central bank changing the way it operates for now, even though it has adjusted the way it communicates on its policy. Any reference to a possible cut in interest rates was deleted from the press release, but according to Mario Draghi, this is not enough to indicate the announcement of a change in policy. The ECB is neither ready nor willing to change policy.

Insufficient inflation, which lags well behind the 2% target set out by the ECB, is the main factor behind this status quo. The President of the ECB again insisted that inflation volatility was solely due to oil price fluctuations. The other components of inflation are much more stable and increased by only slightly less than 1% per year on average over the past three years. This is low and still below the target. The ECB therefore has no reason to rush to change its stance. Continue reading