At first sight, Mario Draghi’s performance on Thursday was an utter disappointment. As expected, he held out the prospect of future bond purchases by the ECB.
However, he did not mention any amounts, dates or interest rate target. For the cursory observer, his statement was vague and woolly. Once again, it looked like European policy makers relying on words rather than deeds. It was all about “may” and “could”.
The dearth of detail turned financial markets off. However, from my perspective, the disappointment about Draghi’s may-day speech is a bit over to top.
If you take a closer look at Draghi’s speech, things start to look differently. Between the lines the message was perfectly clear. The Bundesbank might not like it, but the ECB will intervene in the bond markets in the foreseeable future. And big time.
From my perspective, the most important piece of the speech was Draghi’s implicit acknowledgement that the ECB has a target rate for bond yields. Draghi described the current yields as unacceptable and he stressed that the ECB “may undertake outright open market operations of a size adequate to reach its objective”.
He did not reveal where the ECB’s pain barrier is. However, the mere acknowledgement that the ECB has a certain threshold in mind is quite something. If Draghi means what he says, it follows that the bank is ready to buy bonds without any limits.
Without any doubt, more details and immediate actions by the ECB would have been desirable. However, the good news is that Europe’s central bank is moving in the right direction despite fierce opposition from the Bundesbank.
And Draghi has good economic arguments on his side. If policymakers are interested in preserving economic stability in the Euro zone, they currently don’t have a lot alternatives to bond purchases at the moment.
The trouble is that markets are in a panic mode and just to not work rationally at the moment. Countries like Spain, Italy and Portugal have made quite some progress with regards to fiscal consolidation and structural reform. However, financial markets to not acknowledge this at all. Is is even stressed by the German council of economic advisors, traditionally the holy grail of economic orthodoxy.
According to IMF estimates, the sovereign risk premiums in Spain and Italy are at least 200 basis points higher than justified by fundamentals. The countries are trapped in negative feedback loops. Rising bond yields, declining GDP, growing fiscal deficits and too much austerity reinforce each other. Yet more austerity and structural reforms are not sufficient to break this vicious circle.
Stopping the malicious overshooting on the bond markets is the ultimate rational of bond purchases by the ECB. It’s not about financing public deficits by printing money, as a lot of commentators in Germany suggest. Judged by fundamentals, the sovereign bond market in Europe is just playing up. Given its economic significance, this must not be tolerated.
The Bundesbank and a lot of observers in Germany claim that such intervention was at odds with the ECB’s mandate. From my point of view, this argument does not hold the water. In fact, quite the opposite is true. If the ECB stands idle, the whole monetary transmission mechanism might break down. If this happens, the ECB cannot control inflation anymore and would not be able to fulfil its remit to stabilise the level of consumer prices.
In Germany, a lot of people worry that bond purchases will trigger inflation. However, this fear is misguided as well. As long as these instruments are only used in extraordinary times like today, inflation isn’t in the cards. Southern Europe is suffering from a severe recession, even the German economy has started to tank. Bank lending is depressed, high and rising unemployment as well as inordinate levels of private debt dampen consumer spending.
The currency area is at the brink of a severe recession. Deflation rather than inflation is in the cards for Europe at the moment, especially if the Euro crisis keeps worsening. Disturbingly, fiscal policy and traditional monetary policy has run its course.
Draghi’s management of expectations was iffy and the ECB should act more swiftly and decisively. The delay was probably was due to fierce opposition by the Bundebank. Draghi has to appease the German orthodoxy because he cannot afford that another German central banker resigns. If that happened, most of the media in Germany as well as the public opinion in German would go wild. Hence, strategically speaking, gaining some time seems like a smart move. Conquering the Bundesbank requires a war of attrition rather than a Blitz.
Apart from strategic considerations, however, it might help if the Bundesbank had a look at the economic arguments once in a while. This should lead to the conclusion that bond market interventions are just necessary. For good reason, the institution is besotted with the idea of monetary stability. However, they haven’t understood yet that they have to waive their qualms against bond purchases precisely for that reason. Getting the bond markets out of the panic mode is the biggest contribution monetary policy can make to stability within the Euro area.