ECB, Monetary Policy and Germany – My Monday column

Mario Draghi’s stance is guarded. His latest press conference gave no indication of the change in communication tone that we are set to see from the European Central Bank in January.
The ECB is finally taking on board the strength of the economic cycle and so its communication stance must adapt to this shift. This is rather good news, as the central bank constantly appeared to be acting in reaction to an environment that could swiftly deteriorate, and this shift can bolster our confidence in the strength and length of the economic cycle. The other point noted by the ECB is the move away from an exclusively inflation-based focus and towards a more broad-based communication tone. This implicitly means that the ECB is extending its reach, but really when it comes down to it, this was already the case: the ECB’s intervention has hinged on the economic cycle rather than inflation since the euro was adopted in 1999. The chart below shows the Markit composite index and the difference in the ECB main refinancing rate over 5 months, and reveals that changes in the second indicator are clearly dictated by changes in the economic cycle, rather than in inflation.

The ECB is picking up its old habits from before the 2007 crisis. Continue reading

The ECB top management will dramatically change before the end of 2019

The European Central Bank is heading for a two-year leadership overhaul that peaks with the selection of a successor to President Mario Draghi, and it will be politics as much as ability that determines who get the jobs.
Five of the ECB’s seven top posts will be vacated by the end of 2019, starting with Vice President Vitor Constancio this June. Among the criteria candidates should bear in mind: being a woman is a plus, and appointing a government minister would break with tradition.
Continue reading this article published by Bloomberg here

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The ECB keeps its hands on monetary policy

As expected the ECB has maintained the level of its three interest rates and reduced the size of its asset purchase programme (APP).
The refi rate is still at 0%, the deposit facility rate at -0.40% and the marginal lending facility rate at 0.25%. They will remain at this level way after the ECB will have stopped its asset purchase programme.
This latter has been reduced to EUR 30bn per month from January 2018 until September 2018 except if the profile of inflation doesn’t follow the trajectory as expected by the central bank. In that case the programme could be extended in size and/or duration. (that could be the case as the ECB forecast for the inflation rate is just 1.5% in 2019 (the core inflation rate is also expected at 1.5%). This is way below the target at close but below 2%)).
There are no changes in the forward guidance: 1 – the ECB keeps open the possibility to increase the amount purchased or to extend the period on which it purchases assets. 2- The interest rate will increase only way after the end of the asset purchase programme. It means that Draghi will not not necessarily hike interest rates before the end of his mandate in October 2019.
The ECB will reinvest all the proceeds of its portfolio. It will give details on the 12 month profile of these reinvestments when it will be necessary.
The ECB has not discussed the composition of its APP (between sovereign and corporate bonds) and Draghi said that the APP process was flexible enough to manage the technical constraints that can be faced (not enough bonds to buy in Germany). He didn’t go further in the discussion. (The ECB will be able to mix the APP and the reinvestment to manage the constraint)

Comments:
The ECB is doing like the Fed: it doesn’t want to surprize investors by its decision. No one is surprised by the reduction in the level of the asset purchase programme. The question was on the amount and on the period. But the choice was limited as the ECB gave the open options in the minutes of its last meeting. Moreover speeches from ECB members were transparent on what they could do.
The main surprise is the stability of the forward guidance. Therefore the change in the APP level appears as a technical adjustment and not as a change in the monetary policy stance.
The ECB doesn’t want to tie its hands in the conduct of its monetary policy. It doesn’t want to create the possibility of divergent expectations on investors side. Therefore the forward guidance remains unchanged but this guidance can be changed by the ECB itself without investors pressure. The balance of strength is still on the ECB side and this will not change in coming months. We will still depend on what they want to say, not the reverse.

The ECB decision

The ECB has published an unchanged statement on its monetary policy.
Mario Draghi’s speech was moderate showing that there is no hurry at the ECB in the monetary policy management. No signal on a possible change in the QE framework in the future. The ECB president said that a decision will be taken at the October meeting but said nothing on details of the discussion. Nothing was said on scarcity of bonds in some country and on how capital keys could be respected.
Interest rates are unchanged and will remain low for an extended period. This stability will go beyond the end of the QE. As the ECB forecasts do not show higher inflation in the future and a convergence to the 2% target that will not take place before 2020 we can expect that ECB’s interest rates will remain at the current level (0% for the refi rate) at least until 2019. (see forecasts here)
QE is still at Eur 60bn until at least December 2017. It could be extended after this date if long term inflation expectations do not converge to 2%.

According to the ECB: more growth in 2017 but less inflation all the time

The three charts below show the ECB forecasts for GDP growth, the inflation rate and the core inflation rate. They have been updated today with the ECB meeting.
Growth has been revised on the upside for 2017 but remains unchanged, compared to June, for 2018 and 2019. The inflation rate and the core inflation rate have been revised down. The inflation convergence will not take place before 2020.
Therefore you have to expect that the ECB interest rates will remain at the current level (0% on the refi rate) at least until 2019.
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ecb-2017-september-coreinfforecast

Is the strong euro set to last?

Trading at 1.18/1.19 to the dollar, the euro has become a pricey currency. But the European currency has also gained against all other currencies as its effective exchange rate has returned to levels unseen since the end of 2014. So we can no longer count on the euro losing value. This makes the ECB’s job harder as a strong euro allows for importing disinflation, thereby pushing back the chances that inflation in the euro area will swiftly converge towards the 2% target set by the central bank.

We can make three initial remarks on this situation.
The first is that the euro’s swift rise looks like a monetary restriction. Monetary policy has become more restrictive and the ECB’s stance must confirm its aim for accommodation in the long term so as not to increase potential expectations on a change in course. The second remark is that a strong euro is coherent with the euro area’s very high external surplus. The decline in the euro was not compatible with this surplus. The last remark is that the dollar is weak. Its effective exchange rate is at its lowest since the end of 2016: America is not doing well.

Following on from these three remarks, we can derive three explanations to understand this currency movement. Continue reading

“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.