Mario Draghi’s ultimate meeting as president of the European Central Bank has opened a hectic final chapter for his term. He looks set to complete his period in office as he has often had to govern: in the midst of a political debate initiated by actions he thought necessary to preserve the health of the eurozone.
The European Central Bank has announced its biggest package of rate cuts and economic stimulus in three years and warned governments that they needed to act quickly to revive flagging eurozone growth.
Deposit rates were cut from minus 0.4 per cent to a new record low of minus 0.5 per cent. The ECB also said it would restart its Quantitative Easing (QE) programme, buying €20bn of bonds every month as of next November until inflation expectations come “sufficiently close to, but below, 2 per cent”, at which point interest rates could also start rising again. Also, lending terms for eurozone banks were eased and the central bank offered them tiered interest rates in a bid to ease the pressure on their lending margins.
The ECB cut its forecast for growth in the Eurozone this year by 10 basis points to 1.1 per cent, and by 20 bps to 1.2% for 2020.
It also lowered its forecast for inflation by 10bps to 1.2%this year, and by 40bps to 1.0%next year. In response, the central bank signalled that interest rates would stay lower for longer than previously expected, changing its forward guidance. It had previously said that interest rates would not rise before mid-2020.
In response to Draghi’s offered package the euro fell and bonds rallied — the textbook response to a dose of monetary easing. But three hours later the euro was stronger and bonds had fallen back. It was a rapid unravelling that underlines investors’ doubts about the long-term effectiveness of the ECB’s efforts.
On that front, the bank’s own forecasts suggest it will struggle, sending markets right back in the dust. The ECB has few alternatives to QE — it has, in some ways, become a prisoner of the market’s expectations, much of which it has created.
Quantitative Easing is a way to “borrow” economic growth from the future
It’s been a concern that QE inflates asset prices, rather than doing anything in the real economy. Some fear that QE also damages the business cycle. Whereas capitalism relies on investors backing strong companies and letting weak companies die, QE does not differentiate in the same way, supporting both the strong and the weak.
Most economists agree that, in its early days, QE helped avert a major downturn. But, if growth has previously been borrowed from the future, then we may be approaching that future, from which growth has already been taken.
Digging further into the newly announced package
While on the surface ECB’s announcement was underwhelming, with both the size of the rate cut (-0.10%) and the amount of QE (€20BN), coming in well below what was already priced in, the saving factor in Mario Draghi’s press conference was that the newly restarted QE would be, in the words of the ECB, open-ended.
Which is great in theory, but a nightmare to implement in the bond-constrained Europe.
With one of the most pressing question at the press conference following the decision being just what the open-ended nature of QE meant for the ECB’s existing 33% issuer purchase limits, Draghi was shady: the ECB president admitted there was “no appetite to discuss bond buying limits” instead merely saying that “we have relevant headroom to go on at quite a long time at this rhythm without the need to raise the discussion about limits”.
Because while Draghi may be leaving the ECB by implementing yet another round of QE, the reality is far more problematic, and unless the ECB rule is changed to raise issuer limits to 50% or more, the open-ended QE will be very limited, and that limit will be reached very soon.
How long to reach this limit?
Here opinions differ slightly but converge on roughly 12 months of possible QE under the current limits.
According to Pictet’s Frederik Ducrozet, at the proposed €20bn/month in QE, and assuming a split of €5bn in corporate bonds and the balance in sovereign, QE can run for roughly 9 months under current limits.
Separately, Danske Bank’s strategist Peter Sorensen said that according to his calculations, the ECB can buy German bonds under its fresh €20b per month program for about 14 months. Here, Italy has the most months left at 87, while France and Spain have 57 months and 25 months respectively. On the other end, Finland will have only five months of buying before limits reached while Slovakia has already hit the buffers.
Finally, Credit Agricole’s Valentin Marinov was even less subtle: the FX strategist pointed out that “Draghi indicated that there was no discussion of raising the issuer limit as a way to boost the size of the pool of assets available to buy under QE.” The problem: this will limit the duration of QE at 20 billion euros to between just 6 to 12 months, according to Credit Agricole estimates.
Christine Lagarde may have a subtle card to play
“Now is the time for fiscal policy to take charge”.
During his last official press conference, Mario Draghi also stressed that the eurozone needed tax cuts and more spending.
The blacklash was intense. A number of Mr Draghi’s colleagues on the ECB governing council have joined in with the media criticism. Klaas Knot, the president of the Dutch national bank, published a statement the day after the central bank’s meeting calling the actions “excessive”.
Jens Weidmann, president of the Bundesbank, told the Bild newspaper in an interview that Mr Draghi was “overshooting the mark”. The head of Austria’s central bank, Robert Holzmann, called the decision a “possible mistake”. This public criticism from the Dutch, German and Austrian central bank heads stands in contrast to two French members of the governing council, Benoît Cœuré and François Villeroy de Galhau, who questioned the need for stimulus before the meeting but stood behind the collective decision afterwards.
While the outgoing ECB president has done a lot of work to put in place policies he strongly believes in, he has also created a significant amount of personal animus against himself in the process, especially in Germany. For example, Mr Draghi is very keen to have Germany use fiscal stimulus to boost its own economy and that of its eurozone neighbours. Bringing fiscal policy into the mix certainly would make it easier for the ECB, which has so far had to bear the entire burden of countercyclical macroeconomic policy. But the Italian has become so unpopular in Germany that it would be difficult for a German politician to consider a fiscal stimulus under Mr Draghi’s instruction.
The incoming ECB president, Christine Lagarde, may clearly have a better chance of success. In fact, one of the main reasons Ms Lagarde got the ECB job was her reputation as someone who can get things like a German fiscal stimulus done.
She is also known to be close with Germany’s chancellor Angela Merkel.
The central bank’s purchases will kick back in with an open-ended commitment of €20bn a month, reinvesting the proceeds of maturing bonds. Ms Lagarde will inherit this strategy but not the personal animosities that have developed against Mr Draghi from the hawkish members of the council he has largely bested over the past eight years.
All this is happening against the backdrop of what is expected to be a difficult year for Europe. US President Donald Trump looks ready to impose tariffs against European cars and other products this autumn, which could tip Germany into recession. A no-deal Brexit remains a possibility at the end of October. It is likely that the US-China trade war will not be resolved until the US presidential elections next year. And the stability of the oil market has been brought into serious question by the drone attack in Saudi Arabia. Ms Lagarde is the perfect person to negotiate a “grand bargain” between Berlin and the ECB in which Berlin scales up a fiscal stimulus and the ECB scales down QE.
Cross-Asset Structurer Assistant at Marigny Capital