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Anyone looking at the (admittedly modest) rise in the exchange rate of the Euro or the roughly 10 basis points rise in German (and Irish) 10 year government bond yields might be forgiven for believing that the ECB had tightened rather than eased policy yesterday. A week ago we suggested that any mistakes by the ECB in either the calibration or communication of its policy changes might backfire but we didn’t really expect the sort of developments we saw in Frankfurt and on financial markets in the past twenty four hours.
When Mario Draghi became president of the ECB in 2011, he signalled a substantial regime shift at the ECB by cutting policy rates for the first time since the spring of 2009. In the intervening eight years, the ECB has implemented a range of measures taking monetary policy much, much, further into unknown territory than most would have predicted and many would have liked.
As Mr Draghi prepares to step down next month, there are signs of another important regime shift yesterday and the easing measures he announced today appear to lock his successor, Christine Lagarde, into a prolonged and seemingly almost permanent era of very low interest rates but possibly with little scope to ease policy meaningfully further.
However, Mr Draghi may also have left Ms Lagarde with some potentially major problems. The promise to restart Government bond-buying and to continue this until inflation moves materially closer to target can only be adhered to if the ECB’s Governing council decides to remove some technical limits on the amount of bonds it can purchase from specific issuers. This could be a source of significant friction within the ECB.
While the measures announced by the ECB yesterday were along broadly expected lines, there were two major surprises from Mr Draghi. The first is the subtle but important shift in the emphasis in policy guidance from being ‘date dependent’ (as typified by the ECB’s previous commitment not to raise rates ‘at least through the first half of 2020’ ) to being ‘state dependent’ as evident in the change in today’s opening statement that rates will not rise ‘until we have seen the inflation outlook robustly converge to a level close to, but below, 2%..’ . This approach was further emphasised in the even more surprising commitment to leave the re-started Asset Purchase Programme open-ended.
The second surprise from Mr Draghi yesterday was the increased emphasis on fiscal policy taking the primary role to support the Euro area economy in the future. Today’s statement acknowledges continuing downside risks to the outlook for the Euro area and accordingly the ECB retains a bias to ease further by noting key ECB interest rates are expected to remain at their present or lower levels ( our emphasis) until inflation picks up towards target. However, while monetary policy is set to remain supportive, much more important today in this context was Mr Draghi’s indication that it is ‘now it is high time for fiscal policy to take charge’ . He also said that there was unanimity that ‘fiscal policy should become the main instrument’. So, there is a strong sense that scope for further monetary policy measures is fairly limited.
The ECB introduced a package of easing measures in line with their view that the impact of a package combining a range of policy measures implemented together is significantly stronger than one focussed on a single policy instrument. As a result, in addition to the notable shift in the nature of it forward guidance on policy, Mr Draghi announced four new measures today;
A cut in the deposit rate had been widely signalled with some commentators suggesting it could be a somewhat larger 20 basis points. The decision to opt for a relatively small cut may reflect a growing view that the benefits of such action may not significantly outweigh associated costs (see our earlier analysis' A small step for the deposit rate, a giant leap (in the dark) for the ECB) and Mr Draghi repeatedly acknowledged damaging side effects of negative rates in his comments yesterday. This may be one element of several that hint the ECB monetary policy may be reaching its limits in terms of a capacity to ease further.
Again this measure had been hinted at and, on the initial technical guidelines, this seems to apply to most of the excess reserves presently held by banks in current accounts (other than at the deposit facility) at the Eurosystem, thereby providing some offset to the drop in the deposit rate. The signalled scope to alter the related metrics is not likely to be either sufficient or suitable to become a significant monetary policy tool but it may develop for other reasons.
The ECB cut the interest rate on such borrowings by 10 basis points (depending on the increase in lending undertaken by Banks, the cost for them of borrowing under this scheme will range from the prevailing Refinancing rate (currently zero) and the prevailing deposit rate (now at -0.50%). Also encouraging is the extension of the maturity of such lending from two to three years although an even longer duration with some optionality might have been more attractive. While we previously discussed similar or more aggressive actions of this form and it should have some positive impact on bank lending, changes of this magnitude are unlikely to have a dramatic ‘macro’ effect.
This could prove to be the most notable aspect of yesterday's decisions. There had been significant debate as to whether this form of Quantitative Easing would resume with several ECB officials appearing to downplay its likelihood. Moreover, unlike previous tranches which were strictly time bounded (albeit repeatedly extended), today’s announcement envisages that the APP will be open-ended and will continue ‘to run for as long as necessary to reinforce the accommodative impact of our policy rates’ .
The initial market reaction to what appeared to be a potentially indefinite QE was a sharp drop in the exchange rate of the Euro and a similarly sharp fall in Euro area bond yields but these moves quickly reversed and that reversal developed sufficient momentum to end the European trading session with the Euro exchange rate stronger and bond yields higher than before the ECB measures were announced. Two developments may go some way to explaining the sharp turnaround in market thinking in the wake of the ECB announcements.
First of all, it is questionable whether the ECB can continue to buy Government bonds for very long without breaching its self-imposed limits on the share of bonds it can own from particular issuers. While it has some limited discretion in relation to the proportion in which it buys the debt of various governments, It appears that unless issuer limits are increased, the APP might be unable to properly function beyond a year.
When questioned about this potentially critical constraint, Mr Draghi noted that ‘we have relevant headroom to go on for quite a long time at this rhythm without the need to raise the discussion about limits’. However, he was probably being both evasive and honest when he prefaced this by saying ‘there was no appetite frankly to discuss the limits’ .
This also feeds into the second development that saw ‘sources’ quoted as indicating only a narrow majority of the ECB governing council favoured restoring the APP with several influential voices including those of Jens Weidmann of the Bundesbank, Francois Villeroy De Galhau of the Banque De France and even Benoit Coeuré of the ECB’s executive board opposed to the measure. Overnight, the number of 'dissenters' identified increased notably and this appears to have convinced markets that further ECB easing will not be forthcoming, proving yet again that it is far better for markets to travel hopefully than to arrive.
The market reaction entailing the eventual reversal of its initial response to the restart of the APP seems to reflect a view that ECB bond-buying will be short-lived rather than indefinite. While technical workarounds to the current issuer limits should not be too problematic, the sense may be that many high profile ECB officials are opposed to it may be seen as a more binding constraint on future ECB decision-making particularly in a post -Draghi era.
The significance of this issue is notably heightened by the phrasing in yesterday’s opening statement that the APP will only ‘end shortly before we start raising the key ECB interest rates’. If the ECB does not address a perceived pressing problems with limits, it might be felt that the technically enforced end of the APP towards the end of 2020 would imply a rise in ECB policy rates could follow soon afterwards-an altogether different outcome than is almost universally expected. On some measures, markets currently don’t envisage any material move towards even modestly higher rates until 2024. So, there appears to be some significant disconnect between the apparent assumption by markets that the APP will be short-lived while the era of ultra-low rates is semi-permanent.
Unfortunately for Ms Lagarde (and the ECB’s new chief economist, Philip Lane), this issue poses a potentially major problem for the credibility of ECB policy in that it points towards an inconsistency between the stated intention to make the APP ‘state dependent’, which on the ECB’s latest projections would see a sustained and consequently substantial amount of government bond purchases, and current market thinking that sees technical limits quickly shutting down those purchases presumably because of a forceful opposition within the ECB’s governing council to make any adjustments that would remove those limits.
If Ms Lagarde is to be a successful ECB president, this may prove to be a battle she cannot lose. Moreover, if fiscal policy is to become increasingly important to setting a sustainable and healthy growth path for the Euro area, the restraining influence the APP could provide until inflation returns towards the ECB’s target might represent a meaningful contribution that accords with the ECB’s primary goal of price stability as well as its secondary role in supporting the general economic policies of the EU.
The outlook for the Euro on FX markets and for Euro area term rates continues to be shaped by a wide range of factors. The new ECB projections envisage a slow and modest improvement in growth and inflation will take hold after some potentially bumpy periods in the near term. Beyond this broad economic outlook, market movements may be more significantly driven by surprises possibly related to trade tensions and/or Brexit. Yesterday’s ECB actions were intended to remove any expectations of further near term policy changes and put monetary policy on a clear and sustainable path.
Whether that policy path encompasses a softish Euro on FX markets and lower bond yields will only become clearer as the scope for sustained government bond purchases is established. This potentially vexed question may keep the ECB in the spotlight for some time to come. If the ECB acts to remove current market concerns that technical limits on bond-buying will soon bite, the scope for lower bond yields and a weaker currency might increase appreciably. If instead, the prospect of the APP ending soon becomes entrenched, yesterday’s linking in the ECB statement of the timing of that end and the start of ECB rate hikes could entail a major shift in market expectations.
Analysis by Austin Hughes, Chief Economist, KBC Bank Ireland