Thursday, August 2, 2012

ECB's Changing Philosophy is Good for Bond Holders but Bad for the Economy

Last week, a report from Jon Hilsenrath at the WSJ and comments from ECB President Mario Draghi sent markets screaming higher in expectations of an onslaught of monetary stimulus being announced this week. Following the conclusion of meetings by the FOMC and ECB, those expectations are now delayed. Bernanke was the first to disappoint, announcing no new monetary stimulus and merely repeating the obvious pledge to do more, if necessary. Today, Draghi proved that European policy makers will continue to talk a big game while offering little in terms of details or even a plan of action.

While many reports are focusing on the lack of follow through by Draghi, a strong countervailing opinion is presented at Mosler Economics.

Karim writes:Draghi announced significant philosophical changes today. The key announcements were:
  • The ECB was ready to renounce seniority on its bond purchases.
  • The size of future purchases was open-ended: ‘size adequate to reach its objectives’.
  • Future purchases may not be sterilized, as they have been with the SMP so far.
  • Purchases would be front-end focused as that ‘falls squarely in line with monetary policy instruments’. A key instrument is obviously the LTROs. So would imagine purchases would be 3yrs and in on the curve.
The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions [for some action on the ECB side]. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed.Other news was that:
  • As in the excerpt above, purchases would be subject to strict conditionality via the EFSF (i.e., Spain has to accept a Memorandum of Understanding). Fiscal consolidation and structural reform were listed as the key conditions.
  • He threw cold water on the ESM getting a banking license, saying he was ‘surprised by the attention this has received’.
  • Logistics and objectives on bond purchases were TBD by a committee.
  • Further non-standard measures were forthcoming.
  • Rate cuts were discussed but unanimously voted down; as for a negative depo rate he said ‘we are in unchartered waters’, implying the hurdle may be high.
Relative to levels before Draghi’s London speech last week, Spanish 2y yields are 200bps lower, and 10yr yields are 50bps lower.

Whether or not these “philosophical changes” ever become reality remains an open question, but the ideas of renouncing seniority and leaving QE open-ended are clearly a step in the right direction. That being said, Draghi maintains the ECB’s position that further action is conditional on fiscal consolidation and structural reform. In this more important sense, the ECB’s philosophy has not really shifted at all. Describing that philosophy recently (ECB's Means (Lost Decade With High Unemployment) To An End (Structural Reform)), I concluded:
By working to prevent an all out collapse of the EMU, Draghi is merely taking the necessary actions to maintain his position. If Spain or other European countries must “suffer from a decade of recessions with unemployment over 20%” in order to implement the desired structural reforms than so be it.
As long as this philosophy remains in play, the most likely outcome in Europe will be a sustained period of high unemployment with declining or stagnating growth. Operationally this scenario can go on indefinitely but politically the time may be running out.

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