Draghi Says ECB Guidance Allows Rate Cuts on Volatility

European Central Bank President Mario Draghi said policy makers’ pledge to keep interest rates low explicitly allows for cuts in borrowing costs if market volatility resumes.

“The Governing Council has unanimously agreed to incorporate an easing bias that explicitly provides for further rate reductions, should the volatility in money market conditions return to the levels observed in early summer,” Draghi said at the Economic Club of New York yesterday.

ECB policy makers are seeking to prevent volatility in market rates from derailing a euro-area economic recovery that Draghi said was subdued, uneven and fragile. To that end, they pledged in July to keep official interest rates at or below current levels for “an extended period.” Borrowing costs had risen after the U.S. Federal Reserve said it was considering tapering its stimulus later this year.

The overnight rate that banks expect to charge each other by the ECB’s October 2014 meeting, as measured by Eonia forward contracts, was at 0.24 percent in Frankfurt today. The measure was below 0.1 percent in May and climbed as high as 0.37 percent in June before the ECB announced its unprecedented forward guidance.

Unlike the Fed and the Bank of England, the ECB doesn’t give a specific time frame or a link to particular economic data for its rate pledge. Instead, Draghi reiterated that it depends on the outlook for prices.

Conditional Policy

“The path of the policy rates remains conditional on the outlook for inflation,” said Draghi, who is in the U.S. to attend the annual meetings of the International Monetary Fund and the World Bank. “It will be reviewed over time against our analytical framework.”

Inflation in the euro area was at 1.1 percent in September. It’s forecast by the ECB to average 1.5 percent in 2013 and 1.3 percent in 2014. The Frankfurt-based central banks aims to keep annual consumer-price gains just below 2 percent. The benchmark interest rate has been at a record low of 0.5 percent since May.

ECB officials considered a rate cut at their meeting last week and decided against it. Draghi said at a press conference that the central bank is ready to use “all available” tools to contain market rates, a comment reiterated yesterday in its monthly bulletin.

Liquidity Measures

Economists don’t predict a further reduction in official rates for now, and see the central bank pursuing non-standard monetary policy instead, according to a monthly Bloomberg News survey.

While almost three in four respondents predicted Draghi will unveil new liquidity measures such as longer-term refinancing operations, the majority said interest rates will remain unchanged through the first half of 2015, according to separate surveys published yesterday.

One challenge facing the euro area’s financial system is a review of lenders’ balance sheets by the ECB next year before it takes over as the region’s single bank supervisor. That assessment and subsequent stress tests may identify capital shortfalls that need to be plugged.

“I have no idea whether to expect major disasters or not,” Draghi said yesterday. “Certainly, what is happening, what is positive, is that in view of this exercise, banks and supervisors are reacting very, very strongly everywhere. In convincing banks to raise more capital, in forcing very high levels of provisions in some parts of the area, so this is quite good.”

Policy Limit

ECB Governing Council member Jens Weidmann said in a speech to the IMF that there is a limit to how much central banks should do.

“Central banks have already contributed extensively to the reduction of stress in financial markets,” Weidmann said in the speech posted on the IMF’s website today. “They should not be overburdened by demands to absorb additional risks or make further contributions to repairing private-sector balance sheets. Rather, they must be free to focus on their main task, which is to establish and maintain price stability.”

(Updates with Weidmann comment in final paragraph. See GMEET for more on the Group of 20 and IMF meetings.)
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