Draghi Rate Pledge Weakened by Recovery It TargetsJeff Black and Jana Randow
Mario Draghi’s pledge to keep rates low for an extended period is being complicated by an economic recovery that’s arrived sooner than he expected.
Less than two months after the European Central Bank president pledged to keep rates at or below current levels, data show the 17-nation bloc has emerged from its longest-ever recession and is poised for further growth. The U.S. is strong enough for the Federal Reserve to consider paring stimulus and the U.K. is picking up. That’s helped pushed rate expectations back to levels that Draghi has called “unwarranted.”
Economists from JPMorgan Chase & Co. to Berenberg Bank say that while the ECB is getting the expansion it predicted, it may struggle to prevent borrowing costs from rising too high. That threatens to choke an economy still suffering from record unemployment, bank lending that has contracted for more than a year, and continuing recessions in Spain and Italy.
“Clearly you have the economic recovery, but the ECB will want to curtail any particularly strong moves,” said Sarah Hewin, head of research at Standard Chartered Bank in London. “The last thing you want to do is cut short the recovery.”
German bund yields have risen as investors transfer money to riskier investments that offer higher returns. The yield on the 10-year note climbed as high as 1.98 percent on Aug. 23 from a record low of 1.15 percent in May. It was at 1.86 percent at 2:56 p.m. in Frankfurt today.
The overnight rate that banks expect to charge each other by the ECB’s August 2014 rate meeting, as measured by Eonia forward contracts, was at 0.27 percent today, near the level in late June that triggered Draghi’s July 4 pledge to keep rates low for an extended period. It fell as low as 0.09 percent on July 8.
The euro-area economy grew 0.3 percent in the three months through June, ending six quarters of contraction, and the region’s services expanded for the first time in 19 months in August. Economic confidence in the currency bloc probably rose to the highest level in 17 months, according to a Bloomberg News survey before a European Commission survey this week.
Rates have also been pushed higher as a U.S. recovery prompts Fed officials to debate when to begin slowing their $85 billion a month in bond purchases. At their meeting in July, Fed officials said they were “broadly comfortable” with Chairman Ben. S. Bernanke’s plan to unwind purchases this year, according to minutes released Aug. 21.
Investors have likewise added to bets on higher U.K. interest rates, even after the Bank of England under Governor Mark Carney pledged to keep its key rate unchanged at 0.5 percent. Carney said today that officials are ready to add stimulus if investor expectations for higher interest rates rise too far and undermine the recovery.
“Markets will expect the ‘extended period’ during which the ECB has said its interest rates would stay low or lower to become shorter,” said Christian Schulz, senior economist at Berenberg Bank in London. “That creates a challenge for Draghi. He’ll need to appear as dovish as possible to avoid premature talk of an exit from the ECB’s accommodative policy stance.”
Draghi’s way of doing that so far has been to stress the fragility of the economic revival. His Aug. 1 assessment of the economy placed the balance of risks to growth “on the downside” and he warned that inflation, forecast to average 1.4 percent this year, is lower than the ECB would like.
If the disconnect between economic data and the ECB outlook continues, policy makers’ current approach may not be enough, said Greg Fuzesi, an economist at JPMorgan Chase in London.
“As growth picks up, you’re still left with the suspicion that their thinking will change as the growth data improve,” he said. “Are they able to stick to the script on extended period guidance? I don’t think they’re making the economic case very clear.”
The euro-area recovery has a long way to go. The jobless rate hasn’t yet fallen from its record high of 12.1 percent and youth unemployment was at 23.9 percent in June. Bank lending to households and companies fell 1.9 percent in July from a year earlier, the most on record and the 15th contraction in a row. The economies of Spain and Italy both shrank last quarter.
“High unemployment, weak housing markets and still-tight credit conditions will also help keep domestic demand in many euro-zone countries subdued,” said Martin van Vliet, senior euro-area economist at ING Groep NV in Amsterdam.
While the ECB currently forecasts a contraction in the euro-area economy this year of 0.6 percent, new forecasts due on Sept. 5 will be key to assessing the central bank’s confidence in the recovery and the strength of its forward-guidance pledge.
ECB Governing Council member Ewald Nowotny said on Aug. 22 that he sees few arguments for a cut in interest rates after a “stream of good news,” while his Cypriot counterpart Panicos Demetriades argued two days later that a rate cut is “still on the cards.” The euro area is displaying “uncertain positive signals,” Finnish governor Erkki Liikanen said Aug. 26.
While Draghi still has measures at his disposal to manage market interest rates, including a cut to the benchmark rate, currently at 0.5 percent, further long-term loans to banks, or even charging banks to hold deposits at the ECB, keeping rates tamed has become more difficult.
“Something fundamental has changed,” said Michael Schubert, an economist at Commerzbank AG in Frankfurt. “If the economy continues to improve, the ECB faces a dilemma. They can’t talk down the recovery, neither can they afford to trample on the shoots of growth.”