Sunday, November 20, 2011

No help from the ECB?

Just when many (myself included) thought that the ECB was poised to rescue the eurozone, Paul Krugman pointed out this disappointing speech by Mario Draghi on Friday. First, the ECB chief noted the weakness in the eurozone economy to justify the recent 25 bp interest rate cut, in the context of its "price stability" mandate [emphasis added]:
Activity is expected to weaken in most of the advanced economies. This is the result of a weakening of various components of aggregate demand, both domestic and foreign. And it is evident in ‘hard’ data as well as survey data.

In the euro area, downside risks to the economic outlook have increased, and the weaker degree of activity will moderate price, cost and wage pressures.

This is why the ECB decided to reduce its key interest rates by 25 basis points on 3 November, acting in full compliance with its mandate to maintain price stability in the medium term.
He then went on to discuss his principles for managing the ECB:
Let me use this occasion to dwell a bit further on monetary policy in the current environment. Three principles are of the essence: continuity, consistency and credibility.
Note how many times the terms "price stability" and "anchoring inflationary expectation" are sprinkled in the speech:
Continuity first and foremost refers to our primary objective of maintaining price stability over the medium erm.

Consistency means to act in line with our primary objective and with our strategy both in time and over time.

Credibility implies that our monetary policy is successful in anchoring inflation expectations over the medium and longer term. This is the major contribution we can make in support of sustainable growth, employment creation and financial stability. And we are making this contribution in full independence.

Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs.

These three principles – continuity, consistency and credibility – are at the root of the Governing Council’s outstanding record during the past 13 years in terms of price stability and anchoring inflation expectations
Draghi went on to say that the medium term fix is up to member governments, thus washing his hands of responsibility for saving the eurozone:

But in the euro area there is a third essential element for financial stability and that must be rooted in a much more robust economic governance of the union going forward. In the first place now, it implies the urgent implementation of the European Council and Summit decisions. We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?
What about the stresses showing up in the banking system today? Draghi acknowledge those and said that they had taken technical steps to address them [emphasis added]:
We are aware of the current difficulties for banks due to the stress on sovereign bonds, the tightness of funding markets and the scarcity of eligible collateral. We are also aware of the problems of maturity mismatches on balance sheets, the challenges to raise levels of capital and the cyclical risks related to the downturn.

In the money market, we see rising spreads between secured and unsecured segments, and a widening of repo prices between different types of collateral. Interbank activity remains subdued and concentrated in the very short-term maturities. This limited activity is reflected in increased recourse to our liquidity-providing operations, as well as to our deposit facility.

So far, the ECB has taken several non-standard measures to ensure that short-term funding does not represent a problem for euro area banks. The most important non-standard measures are the fixed rate full allotment procedures and the longer-term refinancing operations. We have also implemented three additional US dollar operations, which cover the end of the year, and we have launched a second covered bond purchasing programme.
He ended the speech with a statement that said, in essence, that we mustn't be panicked into drastic action that we'll regret later:
In spite of the current challenges faced by the global economy, we must resist temptation to resort to unilateral policies, and we must work together to ensure that the gains achieved are firmly secured for future generations.
Does this sound like someone who is about to turn around and print €1-2 trillion to save the eurozone? Or is he just posturing in order to brandish his anti-inflation credentials to the Germans? Will he even print if Merkel gives him the nudge-nudge-wink-wink approval?

If I were to take that speech at face value, then the most generous interpretation is that Draghi is saying that we will not print unless the ECB mandate is changed. In that case, the markets won't like this at all.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Seattle Sunrise said...

Mr. Hui,

I stumbled upon your blog and love your insight. Do you know other sites/blogs I should read frequently? I read Hussman's weekly commentary.


Macro Rants said...

Come on Cam

You can't rescue the Euro by violating the treaty it was founded on (which prohibits the ECB from monetizing bad debts).

And you can't save the EU by ignoring the will of the people; survey after survey in Finland, Germany, Austria, Poland and Netherlands (aka the countries that would have to bail out the losers) -- have said NO!!!

Democracy is dead if arrogant government officials decide to ignore this.

If you want to propose eliminating the article that prohibits ECB bailouts -- that is essentially admitting the Euro, as-is, cannot be saved.

If you open the treaty to renegotiation, what would stop the changes at just that? Why not add a clause to evict countries that ignore deficit / debt limits?

And if an Italian banker (Draghi) is the one who starts monetizing debts? If the EU is going to act Italian, it will have to pay Italian (not German) interest rates.