Against the tide: Draghi’s dilemma
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Against the tide: Draghi’s dilemma

The ECB president is striving to stave off deflation in the eurozone yet Germany will not countenance full quantitative easing. Something must give.

As the eurozone economy continues to stagnate with a significant risk of deflation, ECB chief Mario Draghi finally got enough support on the ECB board to announce at its September meeting a form of quantitative easing, namely by buying private-sector assets (ABS and covered bonds) starting this month. Also, policy interest rates were reduced to the zero bound.

Draghi, though, is faced with a dilemma. He wants to boost credit to the banks to avoid deflation, but he cannot introduce full and outright QE – buying government bonds – because there is opposition from the Germans to this on the ECB board. And he also knows that the ECB can only do so much to get the euro economy moving. That requires fiscal action and structural reform, which is not forthcoming so far. The ECB measures should have increased interest from eurozone banks in the new credit that ECB is offering through so-called targeted long-term repo operations (TLTRO). So it was worrying that the first auction of these in mid-September attracted a very low take-up. After all, the aim is to expand the size of the ECB balance sheet from $2 trillion to $3 trillion, in other words to the levels reached at the height of the euro crisis in early 2012, in the hope that this will boost lending into the real economy and lower the value of the euro to help exports.

The relative failure of the first quarterly TLTRO auction suggests that Draghi might yet have to consider ‘pure QE’, namely for the ECB to start outright purchase of sovereign debt – government bonds – to meet the balance sheet target. Germany remains resolutely against this, although it can be outvoted. Draghi has made it clear that the governing council is ready and willing to do more.

Unwittingly helpful

At least the Federal Reserve is unwittingly helping the ECB to weaken the euro by hinting at its last meeting that it might raise US interest rates quicker and faster than previously expected.

Fed chief Janet Yellen had argued that things had not changed from the previous Fed position that the US policy rate would stay unmoved “for some considerable time”. But what has changed is that any Fed move is now dependent on any improvement in key economic data and not just on the slack in employment.

The market takes that to mean a shortening of the time to move and the US dollar has strengthened against the euro.

Will the proposed ECB purchases of asset-backed securities work to boost lending and lower the euro rate further? Although the ABS market in Europe died a death following the financial crisis (around €150 billion of ABS is currently outstanding), there is certainly now an incentive to repackage loans in this format, which should increase supply. And the inclusion of residential mortgage-backed securities in the eligible ABS bucket expands the stock of loans available for the ECB to purchase to just over €1 trillion.

More eurozone countries have slipped into outright
deflation; Spain is the latest victim. The story is even
worse when stripping out tax changes

If the US interest rate differential over the ECB rate widens (as forward markets are pricing in), that suggests a fair value for the euro at $1.15. That would be good news for avoiding the risk of eurozone deflation. Draghi has been at pains to point out that inflation expectations remain “anchored”. But it has been clear for a while that inflation expectations are shifting downwards, compromising the ECB’s mandate. Even the ECB’s own forecasts suggest eurozone inflation will get nowhere near the ECB’s 2% target without further action.

Eurozone HICP: y/y percentage change
Source: Eurostat

Indeed, more eurozone countries have slipped into outright deflation; Spain is the latest victim. The story is even worse when stripping out tax changes. At the eurozone level, inflation (stripping out tax effects) was a mere 0.18% year on year in July, compared with the 0.38% headline number. So US inflation is 10 times the eurozone’s at a constant tax level.

The ECB can only do so much. Draghi’s speech in August at the Federal Reserve annual summer symposium at Jackson Hole placed strong emphasis on the need to push ahead with structural reforms and to use fiscal policy (within the established framework of debt and deficit reduction) more effectively to foster recovery. But Draghi’s September move tells markets that the long awaited cyclical shift in the euro is upon us. And now it is not just Fed policy that is dictating the running, but also the ECB.

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