It does not often happen that an official interest rate change comes as a surprise for the assembled press and “central bank watchers”.
However, on 7 November 2013, such a surprising event took place at the head-office of the European Central Bank (ECB) in Frankfurt, Germany, when Mario Draghi released the following rate changes:
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.25%, starting from the operation to be settled on 13 November 2013.
- The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
- The interest rate on the deposit facility will remain unchanged at 0.00%.
This surprising rate change was accompanied by this press conference by Draghi, of which I print the following snippets, accompanied with my comments.:
Draghi: First, based on our regular economic and monetary analyses, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain unchanged at 0.00%.
These decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%.
In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.
My comments: Clearly, there are deflationary pressures within the Euro-zone and the European markets. This should not come as a suprise for steady readers of this blog. At best, the inflation rate will remain quite low and considerably removed from the ECB’s target inflation of 1.75%. When thing go worse, the inflation might hit the negative boundary.
And the growth of the Euro-zone also seems to remain disappointing. Therefore Draghi took out his bazooka and slammed the refi-rate in half: to 0.25% from 0.50%. At the same time, he emphasized that banks can borrow as much money from the ECB as they want for as long as it remains necessary.
Second, following today’s rate cut, the Governing Council reviewed the forward guidance provided in July and confirmed that it continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation continues to be based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy and subdued monetary dynamics.
My comments: low inflation, or even deflation, might be the name of the game in Europe in years to come. This is a nightmare scenario for the ECB, as it could lead to a Japan scenario of deflation, near-zero interest rates and near-zero economic growth for the next 20 years or more. That Draghi does not confirm this officially, does not mean that it is not true.
Draghi: Let me now explain our assessment in greater detail, starting with the economic analysis. Real GDP in the euro area rose by 0.3%, quarter on quarter, in the second quarter of 2013, following six quarters of falling output.
In addition, real incomes have benefited recently from generally lower energy price inflation. This being said, unemployment in the euro area remains high, and the necessary balance sheet adjustments in the public and private sectors will continue to weigh on economic activity.
The risks surrounding the economic outlook for the euro area continue to be on the downside. Developments in global money and financial market conditions and related uncertainties may have the potential to negatively affect economic conditions. Other downside risks include higher commodity prices, weaker than expected domestic demand and export growth, and slow or insufficient implementation of structural reforms in euro area countries.
My comments: How do you describe ‘a period of stagnation with anemic growth’ without calling it stagnation?! Well, this is how you do that! In very disguised words Draghi hints to the politicians to hurry up with their economic reforms.
Politicians, however, will remain reluctant to do so, as it might cost them the next elections.
Draghi: According to Eurostat’s flash estimate, euro area annual HICP inflation decreased in October 2013 to 0.7%, from 1.1% in September. This decline was stronger than expected and reflected, in particular, lower food price inflation, a larger fall in energy prices and some weakening in services price inflation. On the basis of current futures prices for energy, annual inflation rates are expected to remain at low levels in the coming months.
Taking into account today’s decisions, the risks to the outlook for price developments are broadly balanced over the medium term. Upside risks relate in particular to higher commodity prices as well as stronger than expected increases in administered prices and indirect taxes, and downside risks stem from weaker than expected economic activity.
My comments: Draghi admits here that he doesn’t see many sources for price inflation, except for rising commodity prices (in my opinion, this will be more on food produce, than on minerals and raw materials, due to the subdued economic activity all over the world) and especially increased taxes and levies.
The economic activities within the Euro-zone seem to point to a deflationary direction. When people like Draghi – whose middle name is ‘optimism’ – point at “weaker-than-expected economic activity”, you can bet that this economic activity is indeed ‘much weaker-than-hoped’! Lately, there were a lot of pundits, who were talking about ‘greenshoots’ everywhere and almost raised the flag that the economic crisis was over.
I was not among them, but apparently Draghi isn’t either!
Draghi: Turning to the monetary analysis, data for September confirm the subdued underlying growth of broad money (M3) and, in particular, credit. Annual growth in M3 moderated to 2.1% in September, from 2.3% in August. Annual growth in M1 remained strong at 6.6%, reflecting a preference for liquidity, although it was below the peak of 8.7% observed in April. Net capital inflows into the euro area continued to be the main factor supporting annual M3 growth, while the annual rate of change of loans to the private sector remained weak. The annual growth rate of loans to households (adjusted for loan sales and securitisation) stood at 0.3% in September, broadly unchanged since the turn of the year. The annual rate of change of loans to non-financial corporations (adjusted for loan sales and securitisation) was -2.7% in September, compared with -2.9% in August. Overall, weak loan dynamics for non-financial corporations continue to reflect primarily their lagged relationship with the business cycle, credit risk and the ongoing adjustment of financial and non-financial sector balance sheets. At the same time, the October 2013 bank lending survey tentatively signals a stabilisation in credit conditions for firms and households, in the context of still weak loan demand.
My comments: M1 is the unit for paper money and easy accessible liquidity available in the market, while M3 represents the money supply in the broadest sense of the word, including bank credit and loans. This snippet is a good example of complicated ECB slang for a situation which can be described quite simply.
What Draghi states here is that the banks are still so busy with repairing their balance sheets, that they continue their refusal to fullheartedly lend money to companies and households, that need it. The banks keep only money available for the safest of investments and only hand out loans when there is ironclad collateral in return.
I can confirm that this is indeed true. Last Thursday I already wrote:
Banks have altered their authorization processes for new loans and credit lines towards SME (small and medium enterprise) and corporate customers. This has not been done out of luxury, but in order to cut unnecessary / avoidable losses for on future loans and credit lines.
At the same time, most companies and households are also busy unwinding their debt (term loans, overdrafts from their current accounts and mortgage debt!) and deploying austerity measures in order to cut expenses.
This leads to a (much) lower demand for loans and also to lower domestic consumption in many European countries. This is the reason that the M3 money supply still remains at a very low level, in spite of the much higher M1 level. Banks hoard cash and companies and households hoard cash too. In spite of the ample availability of liquidity (M1), nobody seems to use it, as a matter of fact.
Draghi: The composition of fiscal consolidation should be geared towards growth-friendly measures which have a medium-term perspective and combine improving the quality and efficiency of public services with minimising distortionary effects of taxation.
Governments must also decisively strengthen efforts to implement the needed structural reforms in product and labour markets. Progress has been made in reducing current account deficits and unit labour cost differentials, but substantial efforts still need to be undertaken with a view to further improving competitiveness, supporting rebalancing within the euro area and creating more flexible and dynamic economies that in turn generate sustainable economic growth and employment.
My comments: What Draghi means is, “governments, stop with taxing your economies into oblivion and don’t kick the can down the road when it comes to the necessary reforms of your labour market and other problem zones within the economy”. And the last phrase must be a warning towards especially Germany and The Netherlands, that these countries must stop with exporting the hell out of the southern and eastern European countries.
Their export policy leads to mounting imbalances on the current accounts within the Euro-zone, with huge surplusses for Germany and The Netherlands and enormous deficits for the PIIGS and the Eastern European countries. In my opinion, Draghi is absolutely right here.
Unfortunately, I’m convinced that this message will fall on deaf ears: wage restraint is still the weapon of choice for politicians, employer’s associations and the labour unions in Germany and The Netherlands, in spite of a growing number of high-brow adversaries against wage restraint in the latter country. Wage restraint and wage reduction leads to cheaper exports for these exporting countries and to “false” competition for the domestic producers in the importing countries,
Draghi: The ultimate objective is, to have the private sector investing in the banking sector. Of course, we want to reach many other objectives with the comprehensive assessment, but the idea of coming out with banks that, in order to become stronger and healthier, have to be more transparent, is really underlying the whole process.
My comments: Draghi wants people to buy bank stock. However, people don’t trust the banks yet, because they don’t know the contents of their (opaque) balance sheets. Ergo, you don’t buy stock in companies that you don’t trust.
After the official statements by Draghi, there were a few interesting questions from journalists in the audience.
Question: What seems to be astonishing about today’s announcement is how unprepared the market generally was for it. I have seen various comments that it was a shock announcement and that it was very aggressive, and it has clearly taken the market by surprise when you look at the reaction in euro/dollar and some of the equity markets. So, my question really is about the communication strategy currently that you are pursuing, and the fact that you have decided to make this announcement today. And I ask you, if you could put some texture on this: do you think that the markets have become overly complacent and doubted the credibility of your will to act?
My comments: What the journalist means is: We didn’t see this rate cut coming, as we (i.e. the financial markets) thought you were a wimp, who didn’t have the guts for such rate cuts.
Draghi: In doing so, I think I will abstain from judging the markets. This is one of the hardest things to do and it is usually quite useless because they do what they want, no matter what. So, I will actually urge all of you to read the introductory statement that I read at the last press conference. And it says: “The Governing Council confirms that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation continues to be based on an unchanged overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the economy and subdued monetary dynamics.” Note “unchanged”: it has changed.
Since then, it has changed. And it has changed in a variety of ways. First of all, as I was saying before, it is now broadly-based over a certain category of goods: we see that it is now based on services, energy, processed food, non-energy industrial goods and unprocessed food. It has also changed in the sense that, if you look at the quarterly annualised figures for inflation, they do actually go down in September and October. So that is the big change. Basically, we observe what has happened and that is exactly what our forward guidance was saying. So, if there were to be a change, we could change. In this sense, I have to remark that the credibility of our forward guidance comes out strengthened out of the decision today.
My comments: Draghi doesn’t give a rat’s *ss about how the journalists and the financial markets think about him. He and his colleagues were in for a dramatic gesture and they did so.
The reason for this gesture was that the economy apparently has been developing much worse than everybody is thinking, who has been put asleep by the record-high stock rates everywhere. Draghi and his peers are seemingly scared sh*tless of the deflatory forces that are at work within the EU currently. Therefore, in their eyes, the dramatic rate drop was necessary last week.
Question: Let me go back to the topic of deflation or lower inflation. Some experts are saying that the euro area is now facing the risk of deflation, which is similar to Japan’s experience. Of course, Japan has experienced a prolonged period of deflation, and some experts are saying that the reason for this deflation is that companies put priority on the adjustment of balance sheets and did not borrow money from banks and did not make investments and that this led to deflation. Do you think that the situation in the euro area is now similar to Japan?
Draghi: No, I do not think it is similar to Japan. We have to go back to 2009 and think of what things should have happened since then. What is quite clear is that, to different degrees across euro area countries, the public sector, the private sector and the banking sector where all over-leveraged. Being over-leveraged meant that they had too much debt and not all of their assets were of good quality. So, they had to deleverage. We should not forget that there where bubbles in the construction sector in Spain. But, more generally, it was the situation that in some countries – not all – there was a very high degree of debt. This had to be reduced, or the ratio of debt to assets had to be reduced, or, in the case of the public sector, both deficits and debts had to go down. There was a period of time when most countries actually ran fiscal consolidation programmes and, on the private sector side, there was significant deleveraging, both by corporations and by banks. And these went hand in hand with some other changes in the euro area, especially changes in risk perception which took place in 2011.
You will remember the stress test, the mark-to-market valuations of debt, the absence of a backstop for a long time, and the PSI. All these things have changed the risk perception with respect to sovereign debt. All these factors are at the root of the recession. Now we are coming out of that. If you look at the euro area from a distance, you see that the fundamentals in this area are probably the strongest in the world. This is the area that has the lowest budget deficit in the world. Our aggregate public deficit is actually a small surplus. We have a small primary surplus of 0.7% , compared with, I think, a deficit of 6 or 7% deficit in US, - 6 I think - and 8 % in Japan. This is the area with the highest current account surplus. And it is also the area, as we said before, with one of the lowest – if not the lowest – inflation rate. This does not translate automatically into a galloping recovery. But, actually, it gives you the fundamentals upon which you can pursue the right economic policies. Structural reforms are the necessary and sufficient condition for this to happen. In the absence of that, unfortunately, we are going to stay here for quite a long time.
My comments: it is interesting to see how totally different starting situations can lead to the same end-result, although this is seemingly denied by Draghi.
In the nineties of last century, Japan had an enormous debt rate, due to its incredible commercial and residential real estate bubble. Instead of acting, Japanese politicians failed to address these debt problems and kicked the can down the road. Bad loans and overpriced CRE/RRE were never taken out of the equasion, making that zombie-banks could easily survive in their zombie-state, instead of being wiped out by the government or their competition.
This was the reason that the longterm deflationary period started there, as everybody - banks, companies and people - started to slowly repair their balance sheet and virtually stopped consuming. This led to structurally dropping prices.
In Europe, on the other hand, the situation is absolutely not so bad from an economic and monetary point of view. This is probably the reason that Draghi denies that the current situation in Europe is similar to that in the Japan of the nineties.
Nevertheless, what worries Draghi very much – see the last two sentences of Draghi's comment – is the fact that also in Europe politics refuses to take the bull by the horns.
What he seems to say to the European politicians is: ‘Hey, I cut you some slack with reducing the refi-rate, but now, $^$@#%&, you have to act on your own!!! Otherwise, the current situation will indeed turn into a Japan scenario’.
Therefore it is my guess that (some countries in) Europe do(es) actually run a large risk of entering into a Japan scenario, as European politicians still scare away from taking the difficult measures; measures that are extremely necessary, but that could lead to these politicians losing their re-elections.
Everybody saw what happened with Gerhard Schröder, the extremely brave German ‘Bundeskanzler’ , who took some daring decisions concerning the German labour market and helped Germany to become the strongest country in the EU again: he was slaughtered in the next elections, against Angela Merkel.
This brings us to the million euro question: will this lowering of the refi-rate do any good for Europe and the EU?!
The lowering itself will probably have the same (non-)effect that all the earlier rate drops had for the European economy: virtually none! To quote Albert Einstein: "only a fool does the same thing over and over again, while expecting a different result!".
However, it might do something as a warning towards the European politicians: they should act now, as ECB chairman Draghi has now clearly used up his weapons to save the European economy. The next step would be: free money!
Still, I think that the European politicians are very good in doing, like this message was not meant for them at all. Consequently, Draghi’s warnings will probably remain in vain and the Japan scenario will indeed come over Europe.
Let's wait and see!