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Monday, 8 July 2013

Draghi is dancing on the brink of a further rate reduction.

While Bernanke has started his difficult footwork towards the exit, Draghi has engaged in a minuet of his own to signal that the exit is far into the future and that indeed further ease could come. The ranking of the FED and the ECB in terms of monetary policy ease has changed, or at least is changing, with interesting possible consequences for exchange markets. Factor in Kuroda and Carney for some further entertainment coming from central banks in the foreseeable future.

Draghi`s minuet included several steps toward ease. First, the clear move towards an ECB kind of forward guidance, less precise than that of the Bank of Canada or the Sveriges Riksbank in terms of timing and less tied than that of the FED to a particular economic variable, but still quite a change with respect to the “never commit” mantra of the past. Second, the promotion of  stable money market conditions” nearly to the same level of price stability as the target to which “monetary policy stance is geared”. This must depend on the fear of endogenous tightening, i.e. that the evaporation of excess liquidity, which could be brought about by less demand of ECB funding from banks, could lead to an increase of money market rates from around zero, where they are, to 50 basis points or more. Third, the recognition that risks to price stability are only balanced because the persistent “downside risks stemming from weaker than expected economic activity” are offset by more temporary factors like “stronger than expected increases in administered prices and indirect taxes”. Fourth, the admission that Bernanke´s announcement about tapering has caused a “monetary tightening” “in various segments of the interest rate curve”.

Then why, one could ask, did the Governing Council not lower rates? Two reasons probably explain this. First, as Draghi said, “Recent developments in cyclical indicators, particularly those based on survey data, indicate some further improvement from low levels.” Even if he added that “The risks surrounding the economic outlook for the euro area continue to be on the downside.” Second, in the balance between hawks and doves in the Governing Council, the latter group probably considered to have brought home already quite a lot with the unanimous endorsement of a form of forward guidance and with hints at possible rate cuts in the future. Of course the hints were not as heavy as they would have been if instead of just “monitoring incoming information” they would have monitored it “very closely”, still the message was clear.

The other question is what else the ECB could do, in addition to lowering rates, if it indeed decided to ease further. The next tool, in terms of likelihood, is to bring the deposit facility rate in the negative territory, for which the ECB is technically, but evidently not fundamentally, ready. Then comes the possibility to do something in the Asset Backed Security domain for Small and Medium size Enterprises, but there has been quite some back pedalling on this since the first announcements a few months back: evidently the sought cooperation with other institutions, primarily the European Investment Bank, proved more difficult than forecast. A further possibility would be a new XLTRO, even if this would be odd at the time when banks are returning quite some of the liquidity they borrowed under the two 3 years XLTROs. Finally, the ECB could have recourse to quantitative easing in a grand scale that, in the context of the Euro-area financial system, would necessarily mean purchases of government securities. This measure would, however, run in two difficulties: first, it would rekindle the political fuss about purchases of government securities raised by the Outright Monetary Transaction program; second, if it would follow, as seems inevitable, the capital key of the ECB for purchases, it would mean buying German securities for a third of the total, and it is not clear why the ECB should add to the excess demand of these securities. Overall, the brink of lower rates is close. The distance from the other measures is instead quite large and significant worsening of inflation prospects and inflation conditions would be needed for the ECB to get closer to them.

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