Draghi cuts and markets flip

Last week marked the second time where new President of the European Central Bank, Mario Draghi, governed an interest-rate decision for the Euro area. And for the second time it was and interest rate cut, implying an interest rate on main refinancing operations of 1.00% effective from 14 December. This ties the lowest level in Euro history, which was effective from 13 May 2009 to 13 April 2011. So, loosely speaking the interest rate is back at the financial crisis level. The decision makes sense given the economic outlook for the Euro area: A continuation of high unemployment and absence of inflationary pressures. It was, however, not a unanimous decision.

At the ensuing press conference, Draghi expanded on the economic outlook and emphasized that some of the prolonged economic contraction was due to the crisis in sovereign debt markets. Also, severe downside risks pertaining to confidence issues in the financial sector were singled out as an important factor. As a direct measure towards the latter problem, the ECB announced a number of temporary initiatives to enhance liquidity in the Euro area (among them a loosening of collateral requirements and reserve ratios for loans with the ECB). As for the sovereign debt problem, Draghi emphasized that all euro-area government “urgently need to do their utmost to support fiscal sustainability” and that a new “fiscal compact” consisting of fiscal rules and fiscal commitments are a precondition. Also, he stressed the need for structural reforms.

Following the press statement, Draghi (and Vice-president Vitor Constâncio) took questions from the press. Not surprisingly, given the sovereign debt crisis, most attention was directed to the fiscal issues. Discussing the “fiscal compact”, Draghi essentially touched upon the issues being negotiated by EU governments these days, namely how to rethink the Stability and Growth Pact. He was to me quite blunt (and correct) when stating, although indirectly, that lack of credibility of rules have been of essence in the current situation, and that a more automatic system of fiscal constraints would be needed for credibility. And only when such credibility is in place, will any kind of fiscal stabilization mechanisms be of relevance. This is quite consistent with what I wrote more than 10 years ago with Roel Beetsma in the paper (published in Journal of International Economics in 2003): “Contingent deficit sanctions and moral hazard with a stability pact“.

After dodging some questions on the economic situation of particular countries, Draghi was asked about the Securities Markets Programme (under which the ECB now holds more than € 200 bn. worth of government bonds). Will it be expanded, continued or what? He then, much to my liking, reminded the press about the Treaty on European Union:

“. . . we have a Treaty and the Treaty states what our primary mandate is, namely to maintain price stability. Also, the Treaty prohibits monetary financing. I am old enough to remember that, when this Treaty was written in the early 1990s, some of the countries around that table were actually doing what you suggest doing now, namely some of the central banks of these countries were financing the government expenditure of their governments through money creation, and the consequences were there for all of us to see. That is why, in a sense, this Treaty embodies the best tradition of the Deutsche Bundesbank, whereby monetary financing has always been prohibited.”

Right on! I have, however, always been wondering how a central bank can purchase government bonds and still be acting within the spirit of the treaty (the legal issue is that when the bonds are purchased on the secondary markets and not directly from the government, then the treaty is not violated by the letter). But the ECB has invented some story about the SMP being necessary for the functioning of the monetary transmission mechanism and thereby for the attainment of price stability. I have never really bought that story, and I think that Draghi (probably unintentionally) was close to stating that he doesn’t buy it himself. Asked specifically about the SMP, and whether similar initiatives could be considered state financing and thus against ECB law, Draghi replied:

“. . . one can construct many different cases. But, as I said before, the key thing is that we should not try to circumvent the spirit of the Treaty. No matter what the legal trick is, I think what matters for the people and what matters for the confidence and credibility of the institution is the spirit of this provision of the Treaty.”

That is probably the closest thing to a confession one can get: “No matter what the legal trick is”. At least I choose to be optimistic in the sense that the ECB has a President that is honest, and also tries to emphasize that fiscal support should not be the doings of the ECB.

The financial markets read it the same way, but took it very badly. The news that the ECB may start to live up to what is actually written in treaties, was met by price drops on several already low-priced bonds. The interest rate on Italian government bonds thus rose around 30 basis points, and the Euro dropped 2 percent vis-à-vis the dollar. Markets are really unpredictable. Would they have become happy if Draghi had promised to intensify purchases of government bonds thereby probably putting an end to serious structural reform efforts?

It is rather amazing how left-wing the markets appear to be on these matters!

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2 Responses to Draghi cuts and markets flip

  1. orionorbit says:

    In my opinion, it’s not that the markets have a left-leaning reaction and that they are best seen as centrist agents reacting to an incoherent ECB.

    While I agree with your comments on the government securities held by the ECB, this is only one side of the coin. The other side is that the ECB has no basis whatsoever to fear inflation and has a mandate that requires it to pursue full-employment policies as long as the no-inflation-risk primary goal is not missed. What the ECB has done is not only buy a bunch of stuff they are clearly not allowed to, but fail to honor its secondary mandate which is, ehm, full employment.

    So when I am for instance trading interest rates, I am using a similar NK model to the ones ECB uses and assuming that the ECB will stick to its mandate, I make my trades. If inflation expectations are going up, I am more likely to sell bonds because my model tells me that the ECB is likely to raise rates. Now, the mandate of the ECB and its workhorse NK Smets-Wooters family models, clearly predict when put together that when the risk of deflation is higher than inflation, or that when the risk of medium term inflation has disappeared, the ECB has an OBLIGATION to pursue expansive monetary policy, as long as it doesn’t monetize govt debt. I.e., that the ecb has the following policy constrains:

    1. Above all, no inflation, no deflation. Price stability.
    2. When 1. is not compromised, pursue full employment

    Plus it is also not permited to finance governments, but it IS permited to conduct expansive monetary policy, like buying corporate bonds or US treasuries or printing money and handing them out for free.

    Under the present situation, the rules that the ECB is supposed to follow and the economic models it says it is using clearly point that it should be slashing interest rates and buying up covered bonds and corporate bonds to get inflation expectations and employment higher. If that doesn’t work it should buy every single piece of corporate paper and introduce negative interest rates on reserves and if that doesn’t work either, Draghi it could even hold the next ECB conference from Christiania, CPH, where dressed in a hawaian shirt and holding a marijuana pipe he announces that the ECB will fly helicopters throwing cash at random times and places and will continue doing so until inflation expectations start rising to levels consistent with its mandate. This is not an option that the ECB might or might not pursue, it is the ECBs job. There are plenty of policies that the ECB can pursue to make sure that 1. and 2. above are always true. THAT would give them credibility, because if us, market participants, knew that the ECB will stick to its mandate no matter what, we would carry out its mandate for it. If we knew that the ECB will buy up corporate bonds to pursue full employment, we would buy them ourselves because anything else would lose us money. The ECB and Draghi wouldn’t have to put on hawaian shirts or even lift a finger. If we trusted that the ECB would stick to its mandate (all of it, not just the inflation bit) we would bid up corporate bonds and crush the lending costs of european corporations without the ECB having to take on any credit risk.

    But no, the ECB has decided to ignore half its mandate and then come out and say “we are credible, inflation 2%, INFLATION 2% I TELLS YA!!!”. Well, If we have a deal that I will not kick you or punch you and when I see you I start punching you while screaming “I AM CREDIBLE, I AM NOT KICKING”, I am not credible, period. The ECB has done a bunch of scary things lately. It has effectively told us, market participants that it don’t give a damn about its mandate, and will only honor the part of the mandate that the Germans and the French want it to honor (i.e. full deflation course and buying up the stuff that the ballance sheets of BNP and SocGen are stuffed with). Moreover, the fact that the rate cut was not unanimous shows that the ECB has voting members that either don’t get monetary economics or that they get monetary economics but they will ignore it anyway. This is scary stuff.

    So no, most market participants, myself included, won’t be buying corporate bonds or do anything that our NK toy models tell us to do. The ECB has decided to ignore economics and so will I. I think this is a much better explanation of the reaction of the market, it’s not about right wing or left wing but about the ECB deciding to ignore half their mandate and thinking that they can get away with it as long as they keep yelling that they didn’t ignore the other half. And since I learned to trade on a Copenhagen trading floor, I imagine this interpretation should be pretty consistent with what you hear from my ex-colleagues over there.

    Bottom line, the NK models that we used in order to determine investment decisions no longer apply for the euro zone. They still apply for Sweden because we know the Riksbank will stick to its mandate and reintroduce negative interest rates if things go south, they still apply for the BoE because we know that they will buy up every single gild out there as long as the risks of deflation are higher than the risks of inflation, but the fact remains that the ECB cannot be trusted anymore that they will stick to their mandate, they are simply doing what the Germans and the French want. Moreover, half the ecb’s board wouldn’t pass econ 101.

    Let me just ask, professor, if you asked your students what should the central bank do in the face of a huge output gap and inflation expectations around 1-1.5% and they responded that interest rates should not be lowered, like the ECB dissenters did, would you give them a passing grade?

  2. Thanks for the comment. I think you misrepresent the legal objectives of the ECB. In the “Statute of the European System of Central Bank and of the ECB” (which can be found at http://www.ecb.int/ecb/legal/pdf/en_statute_from_c_11520080509en02010328.pdf), it says in Article 2 (“Objectives”):

    In accordance with Article 127(1) and Article 282(2) of the Treaty on the Functioning of the European Union, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 119 of the Treaty on the Functioning of the European Union.

    Nowhere is “Full Employment” mentioned. In Article 3 of the Treaty on European Union it is mentioned (apparently arising from a “highly competitive social market economy”) among a ton of other socio-economic goals that mostly would agree with. So the way the ECB Statute is formulated, it is way to hazy so to be inferred that the ECB should target full employment (even if it does not compromise price stability). Also, the wording “with a view to contributing to the achievement of the objectives” is so vague that you couldn’t hold anybody accountable to its fulfillment.

    Oh, and I never grade students in public. So you must guess the answer to your question.