June 6th, 2014
News Summary and Commentary
by Edward Harrison, Credit Writedowns
Reposted from a version as updated at Credit Writedowns 05 June 2014
The ECB (European Central Bank) has installed a new economic paradigm for the euro area, one that moves away from front-loaded austerity and comes with non-interest rate monetary accommodation. I want to briefly outline here what this means.
First, the ECB made five principal moves:
- The ECB lowered its benchmark interest rate to 0.50% from 0.75%. This was widely expected in markets and Draghi said in the press conference that the majority of the ECB's governing council was in favor of a cut, with a majority also in favor of that cut being 25 basis points. What Daghi did not say, however, is that the vote for a cut was unanimous. Given how he worded his view of the monetary policy consensus within the ECB, I assume the rate cut decision was not a unanimous one. Given the anticipation of this action, the rate cut alone is not euro bearish per se. But there were other unanticipated moves.
- The ECB lowered the marginal lending rate ceiling from 1.5% to 1.0%. This move was not anticipated. And it is significant given that the national central bank Emergency Liquidity Assistance for euro area banks is priced off of this rate.
- The ECB stated that it would keep the fixed rate allotment in place until at least July 2014. This is the principal refinancing vehicle for the ECB and this forward guidance by the ECB is considerably more dovish than the other two measures. The ECB has done this before. And the ECB is in effect saying that it will keep the liquidity spigots for banks on for at least another year. For banks, this represents a level of certainty that should allow them to shift private portfolio preferences knowing that the liquidity will be there. This is the European equivalent of the Fed'sforward guidance on its policy rate decisions.
- The ECB is exploring ways to re-animate the European asset backed securities market. Draghi said that the ECB is consulting with the EIB to determine how exactly they can go about doing this. However, the ECB is not going to actually buy asset-backed securities. They are merely exploring ways to re-animate this market in conjunction with the EIB.
- The ECB is exploring ways to get full monetary policy transmission to small and medium-sized enterprises. Mario Draghi talked quite a bit about incomplete monetary policy transmission during the press conference. And while he did not release a program to deal with this problem, he did say that the ECB was looking at ways to foster transmission of monetary policy to SMEs. Here, he was more vague than on the ABS program that seems to be further in development.
All in all, I would consider this policy mix fairly dovish. In particular, there were rumors ahead of the ECB rate decision that the ECB was indeed going to move toward non-interest rate monetary means of policy accommodation. In the US, what that meant initially was quantitative easing. However, the ECB cannot perform this kind of policy action because it would be considered monetary financing. Therefore, were the ECB to move to increased non-interest rate monetary accommodation, it would need to use other means. And I believe we are seeing the makings of that policy shift right here.
The telegraphing of how long the fixed rate allotment will stand is a form of rate easing in the sense that it anchors interest rate expectations for banks, allowing them to know with clarity how long they have access to cheap funding. While the ECB wants the result to be increased risk-taking through increased lending, it is not at all clear this will be the effect. Thus far, it has not been. Nevertheless, I would anticipate that private portfolio preferences are going to maintain a risk-on bias, and this will bolster asset prices in Europe.
Another form of non-interest rate monetary accommodation that the ECB mentioned was the ABS program. It is still early days and Draghi stressed that the ECB had not worked out a plan on how to unstick the ABS market. However, the mere fact that the ECB is looking to do so tells you that the ECB is going to go more heavily into non-interest rate monetary accommodation.
The ECB has always been more prone toward non-interest rate accommodation than interest rate policy as it has consistently provided banks with cheap financing. However, now that the euro area economy is sinking further into recession, the ECB seems poised to ratchet its measures up again. And this is where Draghi has tipped us off that the new economic paradigm is in place now. Repeatedly throughout his press conference Draghi talked about the need for medium-term fiscal consolidation. Over and over again, he talked about fiscal matters using the phrase "medium-term". In fact, at one point he came straight out and said that austerity is "contractionary in the short term", such that one needs to take compensating measures to counteract this. He didn't imply that those measures needed to be monetary in nature. However, he did not specifically deny that monetary policy would provide compensation either.
My takeaway from the ECB's decision is two-fold. First, the ECB is going to ramp up non-interest rate monetary accommodation. I believe we are likely to see a greater telegraphing of interest rate policy. The July 2014 fixed-rate full allotment forecast could be a trial balloon that moves us in that direction in my view. However, given that the ECB has been telegraphing maintenance of this liquidity vehicle for some time, I could be wrong.
Second, Europe's economic paradigm has shifted permanently to one of back-loaded fiscal austerity from front-loaded austerity. There is no other way to read Draghi's comments at the press conference. Not only did he talk only in terms of medium-term consolidation, he also specifically voiced approval for slipping fiscal timetables as long as countries did not backpedal on structural reforms. Just as in the Schroeder-Chirac period, when the Germans and the French breached the 3% deficit hurdle, we are now entering an era in which it is officially ok to run deficits larger than 3% as long as the "medium-term" consolidation objectives remain in place.
Now that back-loaded austerity is official EU policy, the questions now go to how far timetables can reasonably be relaxed and whether actual stimulus is going to be one of the "short-term" policy options.
On monetary policy, I do not expect further cuts here. And I think the ECB is going to remain fairly cautious about policy unless a crisis erupts. So, I would expect the ECB to give greater clarity on the ABS program. And if the ECB is daring and the economy deteriorates further, I would also expect the ECB to start moving toward more explicitly anchoring other interest rate expectations instead of just the fixed-rate full allotment.
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