Back in 2012, Mario Draghi vowed to do “everything in his power” to save the euro. Four years later that promise seems fulfilled – both the recent moves by the ECB and the market reaction that followed suggest that we are reaching the limit of what monetary policy can achieve in the euro area.
The ECB exceeded market expectations in terms of the significance and scope of its latest measures:
ECB’s quantitative easing program (QE) was increased from EUR 60 to EUR 80 billion per month and will henceforth include euro-denominated corporate bonds with investment grade;
The interest on deposits at the central bank was reduced from -0.3% to -0.4%, which means that commercial banks will have to pay an even greater price for keeping their excess reserves at the ECB;
A new program for long-term loans to commercial banks (TLTRO II) will be launched; the interest on these loans may be as low as the interest rate on deposits;
The interest rate on the main refinancing operations will be reduced by 5 basis points (to 0%), while the interest rate on the marginal lending facility fell to 0.25%.
Everything looked “fine” until Draghi set out to explain the position of the central bank. The governor of the ECB said he expected there would be no need for a further reduction of the interest rate. Even as Draghi spoke, European markets indices went down and the depreciating euro made a 180-degree turn, registering one of the fastest hourly rises in its history.
Although the movement of the currency pair EUR/USD was impressive, it is the long-term consequences of this statement and the motives behind the market’s response that are most important in the long term. Whenever such a move by a central bank fails, expectations about the effects of further actions are diminished, which leads to a feeling of insecurity, fear of investment and a search for diversification into other markets – the exact investment imperatives that Mario Draghi wants to push out of the system. The question that markets will increasingly ask themselves is: “Was that the end of the capabilities of the ECB?”.
Despite the fact that Draghi did not completely rule out new moves and promised a prolonged period of low interest rates, the nervous reaction of investors clearly shows an undermined confidence in the further ability of the ECB to support the markets. Both Mario Draghi, and Janet Yellen find themselves in a very awkward situation. While Draghi is trying to stimulate the economy (and inflation), his policy of negative interest rates is clearly hurting the banking sector. Yellen, in turn, is sandwiched between unconvincing evidence of economic recovery in the US, negative interest rates overseas and the policy course already undertaken by the Fed to gradually increase interest rates, the persistence of which is vital for the credibility of the central bank and its ability to directs the market.
It Is the Politicians’ Turn
It is evident that Draghi realizes one of the main drawbacks of post-2011 ECB policies. The ECB was able to suppress the interest rates on the government bonds of euro area member states and thus “saved” the integrity of the monetary union. Although this provided governments with some fiscal room in which to maneuver, they did not take advantage of the possibility to implement much needed reforms aimed at improving competitiveness, dooming the European economy to sluggish growth.
2016 will be a long hard walk for the European economy. While the ECB operates on the edge of its mandate in an attempt to move one of its feet forward, the other one is completely frozen in domestic and intra-union social and economic conflicts. There is hardly any political will left for structural reforms – most changes are the result of the dictates of creditors and the ECB over indebted governments rather than from any real understanding of their necessity.
The reaction of the markets shows that the ability of the ECB to paper over the cracks of the EU economic model is already reaching its limit. The attention, unfortunately, now falls back on the politicians. Like all EU citizens know, this is a completely different kind of problem.