European Central Bank (ECB) Press conference September 2016

Lower for longer rates

“Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. We continue to expect them to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.”

..and continued asset purchases

“Regarding non-standard monetary policy measures, we confirm that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.”

Resilient Euro area

“Overall, while the available evidence so far suggests resilience of the euro area economy to the continuing global economic and political uncertainty, our baseline scenario remains subject to downside risks.”

Slow growth expected in Q3 in the Euro Area

“Euro area real GDP increased by 0.3%, quarter on quarter, in the second quarter of 2016, after 0.5% in the first quarter. Incoming data point to ongoing growth in the third quarter of 2016, at around the same rate as in the second quarter. Looking ahead, we continue to expect the economic recovery to proceed at a moderate but steady pace.”

Monetary support essential for achieving target inflation levels

“To sum up, a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed the need to preserve the very substantial amount of monetary support that is necessary in order to secure a return of inflation rates towards levels that are below, but close to, 2% without undue delay.”

European Central Bank (ECB) Monetary policy decision July 2016


Rates left unchanged

“…the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.40% respectively.”

Interest rates expected to be lower for longer

“The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases.”

Monthly asset purchases to continue

“Regarding non-standard monetary policy measures, the Governing Council confirms that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, or beyond, if necessary, and in any case until it sees a sustained adjustment in the path of inflation consistent with its inflation aim.”

European Central Bank (ECB) Press conference July 2016

Mario Draghi, ECB President

Financial markets were resilient post-Brexit with help from central banks

“Following the UK referendum on EU membership, our assessment is that euro area financial markets have weathered the spike in uncertainty and volatility with encouraging resilience. The announced readiness of central banks to provide liquidity, if needed, and our accommodative monetary policy measures, as well as a robust regulatory and supervisory framework, have all helped to keep market stress contained.

The intention is to meet policy objectives by all instruments necessary

“Governing Council continues to monitor economic and financial conditions very closely and safeguard pass-through of monetary policy…If warranted to achieve its objective, the Governing Council will act by using all the instruments available within its mandate.”

Sluggish growth in the Euro area in Q2 2016 expected to persist in the near term

“Euro area real GDP increased by 0.6%, quarter on quarter, in the first quarter of 2016, after 0.4% in the last quarter of 2015. Growth continues to be supported by domestic demand, while export growth has remained modest. Incoming data point to ongoing growth in the second quarter of 2016, though at a lower rate than in the first quarter. Looking ahead, we continue to expect the economic recovery to proceed at a moderate pace.”

Significant headwinds inform a negative growth outlook

“headwinds to the economic recovery in the euro area include the outcome of the UK referendum and other geopolitical uncertainties, subdued growth prospects in emerging markets, the necessary balance sheet adjustments in a number of sectors and a sluggish pace of implementation of structural reforms. Against this background, the risks to the euro area growth outlook remain tilted to the downside.”

To generate optimal results, monetary policy needs to be augmented by structural reforms and fiscal policy

“in order to reap the full benefits from our monetary policy measures, other policy areas must contribute much more decisively, both at the national and at the European level. The implementation of structural reforms needs to be substantially stepped up to reduce structural unemployment and boost potential output growth in the euro area. Structural reforms are necessary in all euro area countries….Fiscal policies should also support the economic recovery, while remaining in compliance with the fiscal rules of the European Union.”

Will there be more QE?

Given that Mario Draghi announced unlimited asset purchases last week, equity markets have been rallying along side the Euro; however, if Draghi ends up exercising his buying power and Bernanke doesn’t announce more QE tomorrow, the Euro rally may be short lived.  Since 2009 (as theory would predict) the value of EUR/USD has been closely linked with the relative size of each central bank’s balance sheet.  The more that the Fed prints, the more the EUR gains against the dollar.  The more the ECB prints, the more the EUR falls against the dollar.

Euro value ECB Fed Balance SheetRecently following two sizeable LTROs the ECB balance sheet has grown significantly to eclipse the Fed balance sheet (in nominal fiat/local currency terms).  The balance sheet would likely expand even further on new outright purchases.  This implies that there could be further downside for the Euro, unless Bernanke acts to counteract.

The ECB’s newfound willingness to expand its balance sheet introduces an interesting game theory aspect to US monetary policy that wasn’t as prominent in 2009/10.  If Bernanke wants a weak dollar relative to other global currencies, he may be forced to act further.  Otherwise we could be looking at a much stronger dollar along with the anti-correlated equity prices that come with that.

Of course, who cares if the numerical value of the S&P falls if the dollars that measure its value are worth more?  Depending on his actions, Bernanke might.

Thoughts on Today’s ECB Action

Equity markets are rallying today on news out of Europe that the ECB stands ready to conduct Outright Monetary Transactions (OMT) of sovereign debt.  This is the second major monetary weapon that the ECB has used to try to combat the European situation.  The other, performed earlier this year, were Long term refinancing operations (LTROs).

Below is a comprehensive list of ECB monetary tools for a framework of where OMT fits vs LTRO (note LTROs were extended to 3 year maturity in 2012).  The table is from a monetary policy primer that the ECB put out in 2011.  It can be found: here.

ECB Monetary Policy Tools
Even though the tools are listed separately, in the current framework, there isn’t much difference between LTRO and OMT.  In both operations, the ECB is effectively taking unwanted sovereign paper of maturity 1-3 years out of the banking system and onto its balance sheet.  The major difference is that the ECB committed to a range of size for LTROs (the two combined ended up being over 1T Euro).  For the OMT, the ECB is keeping the promise open ended.
The other main difference is that it’s unclear to what extent the LTROs were fully sterilized.  Deposits ended up back at the ECB, but the ECB didn’t exactly lock up the new liquidity by issuing ECB debt securities.  The “sterilization”mechanism of the LTRO is that eventually after three years the money comes back to the ECB when the repo is settled.  But until then the money supply is effectively raised.  With OMT reports are suggesting that the ECB will sell current securities holdings and thereby not increase its balance sheet.  This would make OMTs much less effective than LTRO as a QE mechanism.  It would also limit the size of OMTs to roughly 270B Euro of securities that are already on the ECB balance sheet.  However, an important undiscussed tool that the ECB has is the issuance of debt securities to absorb liquidity.  If the ECB issued debt to absorb OMT purchases, this could make even sterilized OMT a program of unlimited size.  This option would effectively be a debt swap, sovereign debt for ECB debt across the entire Eurozone.  With central banks every program has the possibility of being of unlimited size, OMT could formalize it.  That’s the important point.  
Central banks have unlimited authority to print money if they choose to do so.  The reason that the US isn’t in a European-style situation is the unwavering belief that Ben Bernanke stands ready to do everything possible including buying US government debt with printed money to ensure that the US would never default.  Up until now the markets seemed to not believe that the ECB would act similarly, even though the ECB has repeatedly intimated that it would.  Perhaps today the market is finally getting Draghi’s message.  
Ultimately it comes down to whether or not the market believes that Draghi is willing and able to buy sovereign debt in unlimited quantities.  If the market does, then we could have a “long lasting” solution to the European problem–at least as “long lasting” as the US or Japanese debt solution is.  Of course you cant solve an insolvency problem with liquidity and so in the case of all three regions, monetary policy can only be so effective.  If debt and deficits aren’t reduced in real terms then policy has only shoved the burden onto the monetary system with inflation as the result.