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ECB Shows It Can't Be Markets' Best Friend Forever

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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El-Erian: We Will Have a Bit of Market Volatility

The European Central Bank decided Thursday to double down on its unconventional monetary measures and venture further into experimental policy terrain. But the bank didn't go as far as traders had anticipated or hoped: After the announcement, European equity markets plummeted and the euro registered its biggest single-day move since 2009.

QuickTake Less Than Zero

Some were quick to attribute this broad-based asset price volatility to poor ECB communication. Those criticisms may be somewhat justified, but the underlying reasons for the turmoil are deeper and far more consequential.

After assessing the impact of its previous actions on a tentatively improving European economy, the ECB decided to cut its already negative deposit rate even further, prolong its asset-purchase program (known as quantitative easing) to March 2017 and beyond if needed, buy a broader range of securities and reinvest the proceeds of asset sales.

This additional stimulus largely was in keeping with the expectations of markets. But it failed to satisfy because it didn't increase the pace of monthly purchases and because the cut in the deposit rate (of 10 basis points) was rather small.

Market reactions highlighted traders' disappointment. European equities closed sharply lower: The Stoxx Europe 600 Index lost 3.1 percent and Germany's DAX Index fell 3.6 percent. The euro rose almost 3 percent against the dollar.

Some of the volatility was laid at the doorstep of ECB President Mario Draghi, who had seemed to suggest on more than one occasion that the bank could increase its monthly purchases of securities. Instead, the central bank left the amount unchanged, at 60 billion euros a month.

Focusing on communication, however, would be unfair and misleading. The decision Thursday didn't command the unanimous support of the ECB Governing Council. In addition, and more importantly, as I argued earlier this week, Draghi and his colleagues must contend with a delicate policy dilemma. 

The more the ECB yields to the markets' pressure for even more unconventional policies (in duration, composition and scale), the greater the risk that it will aggravate an unhealthy dependency of markets on central bank intervention, which could cause future financial instability, increase the political vulnerability of the central bank and risk encouraging poor allocations of resources in markets and throughout the economy.

These concerns are amplified by broad recognition that, in the absence of additional measures by governments, the beneficial impact of ECB actions on the economy is likely to be limited. On Thursday, Draghi again correctly stressed the need for structural reforms and more appropriate fiscal policies in euro zone member countries.

The immediate implication of the announcement will be to shake out some of the crowded ECB-related bets by traders. At the same time, the strengthening of the euro increases the probability that the Federal Reserve will increase interest rates when its policy-making committee meets in two weeks.

In the longer term, the ECB's actions should temper the very pronounced confidence of financial markets that central banks tend to under-promise and over-deliver when it comes to supporting asset prices. It should also alert traders to the genuine reasons central banks are becoming more cautious in increasing what already has been a prolonged and excessive reliance on unconventional monetary policy, especially when implemented without the support of other tools -- such as national fiscal policies -- that are better suited for the task but are outside the purview of central banks.

But what should happen doesn't always occur, especially immediately. It could take a bigger shock to market confidence for traders to realize that the central banks they have thought of as their "Best Friends" won't necessarily be their comforting "Best Friends Forever."

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net