Draghi Seen Putting Words Before Action on ECB PolicyStefan Riecher and Jeff Black
Mario Draghi is likely to rely on the power of his voice rather than new policies to steer Europe’s banks through the early stages of an economic recovery.
The ECB president will hold off from pumping more cash into the currency bloc’s financial system as long as the threat of action keeps market interest rates under control, according to economists from Berenberg Bank to Nomura International Plc. While Draghi has put investors on notice that a long-term refinancing operation is possible, other policy makers have played down the likelihood of that for now.
“Communication has clearly been the ECB’s preferred tool for the past few months and it still is,” said Christian Schulz, senior economist at Berenberg in London. “Draghi will keep using words rather than deeds. He will say that more long-term loans are still on the table and he may even hint at another LTRO being deployed by the end of the year, but I don’t expect any policy action today.”
ECB policy makers meeting in Paris today will keep the benchmark main refinancing rate unchanged at a record low of 0.5 percent, according to all 52 economists in a Bloomberg News survey. The central bank will announce its interest-rate decision at 1:45 p.m. and Draghi will hold a press conference 45 minutes later. The meeting is being held a day earlier than normal because of a public holiday in Germany tomorrow.
The ECB is trying to shore up the euro region’s recovery by keeping its official interest rates low. At the same time, it says it wants to contain volatility in market rates as investors face risks ranging from a squeeze on excess liquidity to stress tests on bank balance sheets and a political crisis in Italy.
The overnight rate that banks expect to charge each other by the ECB’s September 2014 rate meeting, as measured by Eonia forward contracts, was at 0.21 percent today. While that’s down from 0.3 percent on Sept. 5, the date of the ECB’s last rate decision, it compares with less than 0.1 percent in May.
Expectations of borrowing costs rose globally after the U.S. Federal Reserve signaled in June that it’ll start tapering its $85 billion a month bond-buying program later this year. The drop in the 1-year Eonia forward rate since the ECB’s last meeting has been helped by the Fed’s unexpected decision on Sept. 18 to refrain from reducing its purchases for now.
The ECB issued more than 1 trillion euros ($1.4 trillion) in three-year loans in late 2011 and early 2012, giving banks an option to repay them early, as Europe faced a credit crunch. As banks take up that option, excess liquidity in the euro area’s financial system is approaching a 200 billion-euro level that Draghi has previously signaled as a lower limit. The measure was at 216 billion euros on Sept. 30, compared with a high of 813 billion in March 2012.
The first of the two LTROs expires by the end of next year. While Draghi won’t announce another round today, he may extend a policy of granting banks as much cash as they need until at least July 2014 in regular refinancing operations, according to Richard Barwell, senior economist at Royal Bank of Scotland Group Plc in London. That’s a pledge Draghi made in May.
“It is highly likely that this extension in the guidance on liquidity will be announced within a matter of months, and just about more likely than not this month,” Barwell said. “The extension of the fixed-rate, full-allotment regime out beyond the expiry of the current LTROs, creating a fuzzy end point for the ample liquidity regime, is a more plausible preliminary and potentially final step.”
The ECB’s challenge will be to communicate its intention to keep rates low, which is a stance consistent with a weak or shrinking economy, as evidence mounts that the region is returning to growth. Since the September rate meeting, economic confidence in the euro area as measured by the European Commission rose for a fifth month and a gauge of factory output gained for a third month.
Draghi, speaking to the European Parliament in Brussels on Sept. 23, said that while economic-survey data has signaled the region’s economy will continue to improve, unemployment at 12 percent “remains far too high, and the recovery will need to be firmly established.”
Standard & Poor’s said today that the euro region’s crisis isn’t over yet. The current favorable economic conditions create a risk that governments will slow efforts on fiscal consolidation and structural reforms, the ratings agency said in a report.
Risks to the recovery include a challenge to the government in Italy, the euro area’s third-biggest economy. Prime Minister Enrico Letta faces a confidence vote today after Silvio Berlusconi, the ex-premier whose tax-fraud conviction was upheld by Italy’s Supreme Court on Aug. 1, said he was pulling his party from the ruling coalition.
Investors are relying on Letta to guarantee Italy’s deficit targets and deliver the stimulus needed to end the country’s recession. Draghi was formerly Italy’s central bank head.
“A Letta victory would be a confidence boost for Italy and the euro zone,” said Berenberg’s Schulz. “That should contain the risk of renewed financial market tensions.”
Another potential cause of market volatility is a review of bank balance sheets to be led by the ECB starting next year. Stress tests that form part of the assessment remain a potential source of bank turmoil as no plan to cover capital shortfalls discovered during that process has yet been agreed by European Union leaders.
The view of a gradual recovery with subdued credit dynamics and inflation stands behind the ECB’s pledge since July to keep official interest rates at their present level or lower for “an extended period,” Draghi reiterated in Brussels. Lending to the private sector fell the most on record in August.
“There is no doubt that the ECB still has an easing bias,” said Anders Svendsen, an economist at Nordea Bank Denmark A/S in Copenhagen. “If market rates rise too much the ECB could simply cut the refi rate and thereby narrow the corridor that Eonia moves within. That would flatten the Eonia curve and possibly even bring longer-term rates down as well.”
If the three-year LTRO repayments continue at the current rate, most of the liquidity injected will have been returned by the time the ECB takes over banking supervision at the end of 2014, effectively ending its extraordinary support to the financial sector. ECB Vice President Vitor Constancio said last week that repayments to date represent an “exit in a smooth way” from crisis policies.
“Repayment of the LTROs is first and foremost a good thing as it represents a healing of the financial system,” said Nick Matthews, senior European economist at Nomura International Plc in London. “The more Draghi talks to markets, and keeps the threat-level for an LTRO high, then the more well anchored money market rates will be, the less they might actually need to use it. This is the art of central bank communication.”