Too little or too late for ECB’s President Draghi?

Global central banks are once again making headlines in another valiant attempt to steer their economies forward. Following the credit crisis of 2007, global policymakers took unprecedented coordinated steps into uncharted territory.  

More recently, many officials are going against the grain, reaching across the aisle to broker deals and spur their economies back to life.  

The Swiss National Bank, Central Bank of Denmark and Bank of Sweden courageously introduced negative deposit rates in a fight to starve off massive currency appreciation from investors seeking a safe haven. The Bank of Japan initiated billions of dollars in asset purchase programs coupled with significant fiscal and structural reforms, while countries stumped by the free fall in commodity prices (Norway, Australia and Canada) have moved to either cut their overnight rates or are expected to loosen monetary policies further this year. 

Perhaps most notable was the European Central Bank’s move to introduce massive amounts of liquidity into its banking system. The size and scope of the much-anticipated quantitative easing did not disappoint investors at more than $60 billion in asset purchases at least until September 2016. At approximately 10 percent of the Euro zone GDP, the size of the stimulus might appear small compared to 25 percent for the U.S. and close to 20 percent for the U.K., yet the $1.1 trillion purchases appear to have quieted investors for now. 

Met with much resistance, ECB President Mario Draghi seemed to have won over many of the region’s finance ministers by brokering a compromise to purchase investment-grade sovereign bonds and debt of European institutions and agencies. The highly publicized opposition on “loss sharing” now rests on the shoulders of participating central banks.  

Perhaps the most attractive feature of the program is the limit to single government debt purchases at 33 percent of all outstanding debt, a move that eliminates purchases of Greek bonds given the ECB has already reached its limits via the Securities Markets program. 

Although some skeptics have argued the program may not go far enough, Eurobond yields fell below their all-time lows following the news. The yield on 10-year German bunds tightened to yield 36 bps, while the corresponding Swiss bond extended its move further into negative territory yielding -32bps.  

In addition to the size and scope of the stimulus, the sanguine mood in the markets could also be attributed to the flexibility to extend the program beyond September 2016 “until a sustained adjustment is seen in the path of inflation.” Perhaps the most notable corollary of the stimulus is the fall in the currency, one of the most powerful tools available to jump-start the lackluster economy. 

With 2014 GDP having been forecast at 0.80 percent and inflation at 0.44 percent, a significant catalyst was essential to ward off the growing threat of deflation. But will the actions of the ECB provide similar results to that of the Federal Reserve and the Bank of England? Or are the actions of President Draghi just a little too late?  

While many market participants breathed a welcome sigh of relief, significant headwinds to the euro zone remain.  

A renewed bout of anti-austerity sentiments in heavily indebted peripheries has the propensity to create ongoing frictions within the monetary union. Spain’s Podemos party, France’s Front National and Italy’s Five Star movement are all pushing political agendas that include some combination of debt restructuring and withering commitment to euro membership. Any concessions to the Syriza party by the ECB could make the union’s fiscal targets moot.  

The low level of yields within the euro zone may also result in more muted effects from quantitative easing. With short-term debt essentially truncated at zero, room for further tightening now appears quite limited. This leads some to believe the tightening in yields experienced by the Fed and Bank of England may now evade the ECB.  

Perhaps the greatest challenge to the newly announced stimulus is the ECB’s flexibility beyond its stated time frame. With an already stressed banking sector and euro area unemployment at 11.5 percent, a prolonged economic paralysis of this magnitude may require significant time to unwind.  

Now that the collapse in oil prices has firmly anchored inflation expectations below zero, forces may already be too far along to avert a deflationary environment in the world’s largest economy.  


Disclaimer: The views expressed are the opinions of the writer and while believed reliable, may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information. 
Statistics and Data Source: Bloomberg LP, Capital Economics