Draghi Seen at Guidance Limits as Market Rates Rise

Mario Draghi is discovering the limits of what his interest-rate pledge can achieve.

After three attempts to talk down market rates, the amount that banks expect to charge each other for cash in a year is back to the levels when he started. Government debt yields from Germany to Italy are rising as investors take on more risk. The European Central Bank president conceded yesterday that the unprecedented experiment in ECB communication hasn’t quite reined in investors’ enthusiasm about the euro area’s recovery.

“We have been moderately successful,” Draghi said at a press conference in Frankfurt after keeping the ECB’s benchmark rate at a record low of 0.5 percent. While the promise has been “OK in controlling the levels of rates,” the central bank is “ready to act” if needed, he said.

The overnight rate that banks expect to charge each other by the ECB’s August 2014 meeting, as measured by Eonia forward contracts, was at 0.26 percent at 2:53 p.m. in Frankfurt. That’s near the level before Draghi’s promise on July 4 to keep rates low for an extended period. The rate was as low as 0.09 percent on July 8.

‘Dovish Words’

Germany’s 10-year bond yield was down 9 basis points at 1.96 percent, after closing yesterday at the highest since March 2012. The French treasury yesterday sold 4.24 billion euros ($5.6 billion) of 2023 debt at an average yield of 2.57 percent, the highest at a 10-year auction since May 2012.

Market rates eased today after leaders at the Group of 20 summit meeting in St. Petersburg issued a communique stating that the global economic recovery “is too weak and risks remain tilted to the downside.” They also said that they “remain mindful of the risks and unintended negative side effects of extended periods of monetary easing.”

Yields rose in recent months partly as a reaction to the Federal Reserve’s plan to gradually withdraw stimulus from the U.S. economy. They now also reflect bets that the ECB will let excess liquidity drain from the banking system as the 17-nation currency bloc returns to growth and banks repay emergency loans. Mindful that higher borrowing costs threaten the economy, Draghi stressed that the recovery is still “very green.”

“Dovish central bank talk has had limited effect on market rates recently due to the significant improvement in key figures,” said Anders Svendsen, an economist at Nordea Bank Denmark A/S in Copenhagen. “Dovish words from Draghi are unlikely to have any major impact on rates until key figures stabilize or start disappointing a bit.”

Economic Contraction

The euro area’s economy expanded by 0.3 percent in the second quarter, beating expectations and snapping six quarters of contraction. An index of services and factory output for last month climbed to the highest level since June 2011 and economic confidence soared to a two-year high.

The economy will still contract this year, shrinking 0.4 percent versus the 0.6 percent predicted in June, the ECB said in revised forecasts yesterday. It lowered its outlook for 2014 to an expansion of 1 percent, from 1.1 percent. The inflation forecast for 2013 was raised to 1.5 percent from 1.4 percent, with next year’s estimate unchanged at 1.3 percent.

Credit to the private sector has contracted for fifteen months and unemployment remains at a record high of 12.1 percent. In a further sign that the recovery will be uneven, data today showed exports by Germany, Europe’s largest economy, unexpectedly dropped and industrial production slid more than forecast in July.

Liquidity Drain

Even as Draghi repeatedly warned against overenthusiasm, he didn’t deny the rebound.

“Looking ahead to the remainder of the year and to 2014, in line with our baseline scenario, output is expected to recover at a slow pace,” he said.

“The ECB has not suddenly become wildly optimistic,” said Carsten Brzeski, senior economist at ING Groep NV in Brussels. “Draghi seemed to be concerned about the recent reduction of excess liquidity and its potential impact on money market conditions.”

Excess liquidity in the eurosystem has dropped, helping to push money-market rates higher, as banks have repaid three-year loans under the ECB’s longer-term refinancing operations. The measure has declined to 243 billion euros currently, from a high of 812 billion euros in March 2012.

When Draghi promised in July that ECB interest rates would remain at their current levels or lower for “an extended period,” he broke with the bank’s tradition that policy makers don’t pre-commit on rates. He also followed other central banks.

Policy Tools

U.S. Federal Reserve Chairman Ben S. Bernanke pledged in December that he wouldn’t raise interest rates as long as unemployment remained above 6.5 percent and policy makers project inflation of no more than 2.5 percent. Bank of England Governor Mark Carney adapted that model, saying he would keep borrowing costs low until unemployment falls to 7 percent. His guidance includes so-called knockouts linked to the bank’s 2 percent inflation goal.

As Draghi indicated that his forward-guidance strategy isn’t entirely working on market rates, he stepped up his rhetoric on what the central bank can do about it. During his press conference in Frankfurt, Draghi said four times that policy makers were ready to act.

“Draghi did not say what actions the ECB could take, but a rate cut would be the most likely first step,” said Christian Schulz, senior economist at Berenberg Bank in London. He issued “a thinly veiled threat that the ECB could ease liquidity conditions again with more LTROs or an explicit extension of the full-allotment regime beyond July 2014,” he said.

Inflation Risk

While the ECB president signaled that the Governing Council had discussed a cut in the cost of borrowing “like we do all the time,” he repeated that the central bank’s normal reactions to growth and inflation haven’t changed.

Responding to the prospect of higher oil prices causing a spike in inflation, Draghi signaled he wouldn’t be inclined to ignore such a development. West Texas Intermediate crude climbed to a two-year high on Aug. 28 amid growing concern there will be an American-led military strike against Syria.

“The rate to which we look is the headline inflation,” he said. “So we have to see whether this would alter our medium-term forecasts for inflation.”

“If economic data improves further, the so-far vague forward guidance won’t be able to prevent a further increase of interest rates,” said Marco Bargel, chief economist at Deutsche Postbank AG in Bonn. “The ECB won’t be able to avoid following other central banks in revealing their reaction function or loosening the monetary reins further.”

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