Mario Draghi boosts Europe’s economy but his authority is waning

16 May 2016 - Peter Warburton, Robert Sierra and Federico Corrado

There was a small riot in financial markets last December when ECB president Mario Draghi failed to satisfy expectations of a monetary boost to the Eurozone. When the ECB council met on 10 March, there was considerable pressure on them to deliver a convincing policy response. Draghi did not disappoint, announcing a package of measures that impressed the markets. However, there were a number of dissenters on the council who could obstruct him from taking strong action in future: was this Draghi’s last stand?  
2016 began with renewed doubts over the vigour of the global economy. The Eurozone grew faster (1.5%) than the US economy (0.5%) in the first 3 months of this year and the unemployment rate is falling consistently. On the face of it, there was no urgent need for a new stimulus package from the ECB. The bugbear for the ECB was the very low inflation rate, far below the official target of just under 2%. Neither the December nor the March packages have managed to jolt it upwards and it remains significantly below the central bank’s inflation target (figure 1). The Euro also failed to weaken. In fact, it has appreciated further against the US Dollar.
Agitation over the failure of past attempts at monetary stimulus to lift inflation back towards target lies at the heart of Mario Draghi’s difficulty. He has faced ongoing criticism over the pursuit of his quantitative easing policy from several ECB board members -rumoured to be Weidmann and Lautenschläger (Bundesbank), Knot (Dutch central bank), Hansson (Bank of Estonia), Rimsevics (Latvian central bank), and Jazbec (Bank of Slovenia). Draghi’s critics on the ECB council argue that the monthly ECB purchases of €60bn of Eurozone government bonds have been ineffective in stimulating the economy and lifting inflation.
Draghi was under intense pressure to deliver a strong rebuttal to that charge when the ECB met on 10 March. The bigger than expected package of measures proved the doubters wrong and more than made up for the disappointment that followed the December meeting. The ECB now believes it has done enough to stimulate the economy even if the initial market reaction was lukewarm. That unenthusiastic market response arose partly from the contrasting messages sent out by the actual policy announcements and Draghi’s comments in the subsequent press conference.
A key feature of the March decision is that it shifts the focus of current and future easing in ECB monetary policy away from negative rates. The new TLTROs have been designed to compensate banks affected by the negative rate on deposits at the central bank. In principle, the new TLTROs will offer funds at zero or negative rates to banks which increase lending to households and corporations. These particular negative (borrowing) rates seek to protect commercial banks’ profitability by offsetting the effects of the recent 10bp cut in the ECB’s deposit rate.
What more could the ECB do? Rather than pursue new policies at this stage, the Bank is arguing for existing ones to be given time to work. Indeed, the programme of corporate bond purchases that was announced in March does not become effective until the end of June. Little detail has been provided as to the likely size of the corporate purchases or the criteria that will be used in selecting them. Estimates of how much the ECB could buy range from €300bn to €750bn over the coming year. These purchases should lower the cost of borrowing for large corporations and underpin economic recovery.
The decision to buy private sector assets was not an easy one for the Bank to make given the risk of benefiting certain countries at the expense of others. Nevertheless, the ECB has argued that while some jurisdictions do have more corporate bonds than others, the expectation is that the initial effect of the Bank’s purchases will spread to other assets and other markets.
The ECB has so far tried government bond purchases, lowered deposit rates below zero, announced corporate bond purchases and another round of liquidity injections. It could still widen the choice and pool of assets it buys. In principle, the scope for assets purchases by central banks is unlimited. In a crisis such as that of eight years ago, the central bank could buy stocks, real estate or any other asset it wishes to should financial markets go into free fall. The Bank is not out of ammunition, by any means, but there is perhaps a limit to how much Draghi can personally keep on asking from his more reluctant colleagues at the ECB. His term as president runs until 2019, but his authority is weakening. Like European equity investors, he will be hoping that the European economic recovery proves vigorous enough for further stimulus to be rendered unnecessary. 
Figure 1
Data source: Datastream

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