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ECB’s Message Bears No Contradiction – Read the Speech!

Sam Wardwell
calender-icon Posted on August 09, 2012


Comments by European Central Bank (ECB) President Mario Draghi caused a little bit of turmoil in the markets recently, when he first stated the ECB would do “whatever it takes” in a speech on July 26, then expressed the ECB’s reluctance to intervene in sovereign bond markets in his August 2 press conference. The markets soon bounced back to recover any losses.

The highlight of that press conference (for me at least) was when a journalist challenged Draghi, suggesting he was sending contradictory messages and thus contributing to volatility by suggesting the ECB stood ready to buy government bonds at the end of July and then saying the opposite in his most recent statement. Draghi’s response was:  “Did you read the speech?  No. Well, then if you had read it…there was no reference whatsoever to a bond buying program…read the speech.”  (I wouldn’t have wanted to be that reporter when he met with his editor the next day.) 

There is, in fact, no dissonance or contradiction in the message I see coming out of the ECB or from Draghi.  The issue was that journalists and market commentators apparently didn’t actually read his speech (or didn’t have the market knowledge to understand what he said in pretty clear English).

What the speech said was, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.”  The phrase ’within our mandate’ makes all the difference.  Most of what politicians and investors are hoping for (monetizing budget deficits or bailing out investors whose positions are underwater) falls outside the mandate of the ECB.  The ECB’s only mandate is price stability—defined as inflation below, but close to 2% over the medium term. 

Note also that the Draghi was saying the ECB would do “whatever it takes” only in pursuit of the objective of preserving the euro…no mention of employment, growth or easing the pressure on governments to balance their budgets.

Sloppy journalism and wishful thinking by investors sparked a brief rally. The August 2 statement and press conference reset expectations. For those who do wish to ‘read the speech’, here’s a link:  http://www.ecb.int/press/key/date/2012/html/sp120726.en.html

ECB Policy Under Draghi

Between the July 26 speech, the August 2 ECB statement and the press conference, Draghi and the ECB have laid out a pretty clear statement of what they see as the problems, the ECB’s role in solving them, and the preconditions for the ECB to act.  I’ll pause here to note that I’ve done my best to relay, verbatim, all quotes that follow.

In essence, Draghi reaffirmed the ECB commitment to its mandate of price stability, reaffirmed its absolute independence of national governments (and markets and journalists) in setting monetary policy, and said the ECB would only intervene after governments have fulfilled the necessary conditions, namely undertake fiscal and structural reforms and apply to the EFSF with the right conditionality . . . and at that point we may act if needed.”

Financial Fragmentation and The Role of Regulation

The July 26 speech focused on the ECB’s growing concern about “the financial fragmentation that has taken place in the euro area. Investors retreated within their national boundaries. The interbank market is not functioning. It is only functioning very little within each country by the way, but it is certainly not functioning across countries.” 

The speech highlighted regulatory policies as a central part of the financial fragmentation problem, saying that the current liquidity regulations make interbank lending a money losing proposition and that national banking supervisors have asked the banks under their supervision to withdraw their activities within national boundaries and ring-fenced liquidity positions . . . a policy which may appear appropriate at the single-country level, but is counterproductive if generally applied. 

Liquidity, Credit, and FX Risk

The July 26 speech also addressed three factors influencing bond yields and how the ECB might respond to each:

  • To the extent that liquidity is the problem, the ECB has the ability (and willingness) to provide essentially unlimited liquidity.
  • To the extent that sovereign bond yields reflect the market’s assessment of credit (default) risk, the ECB has no role to play.
  • To the extent that sovereign bond yields reflect fears of currency convertibility (e.g. being repaid in drachma rather than Euros), the ECB will firmly assert its view that the move to the euro is irreversible…but (in my assessment) it can do little other than jawbone the market.  Hence the statement “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

High Thresholds for Intervention

If I were German, I would feel quite reassured by statements made by Draghi and the ECB at that point.  Rather than being more willing to resume purchasing peripheral sovereign government bonds (the market’s apparent hope) by restarting the SMP, the ECB appears to be taking a hard line.

  • Draghi poured cold water on the idea of giving the European Stability Mechanism (ESM) a banking license (to allow it to leverage up to purchase more sovereign debt), saying “I’m surprised by the amount of attention this has received…I did say at least twice that the present design of ESM doesn’t allow for this.  It’s not up to us to give a banking license; it’s up to the governments.  It’s up to us to decide whether the ESM even with a banking license can actually be a suitable counterparty eligible for being financed.  And I did say the current design of the ESM does not allow it to be recognized as a suitable counterparty.  And we have a legal opinion of the ECB issued way back in February on this.”
  • The barriers to further ECB bond purchases appear to have been increased.  “The first thing is that governments have to go to the EFSF because, as I said several times, the ECB cannot replace governments, cannot replace the actions that others have to do on the fiscal side…which means that to go to the EFSF is a necessary condition but not a sufficient condition because monetary policy is independent…. We have explicit conditionality of adherence as a necessary condition.”…“when governments have fulfilled the necessary conditions, namely undertake fiscal and structural reforms and applied to the EFSF with the right conditionality…and at that point we may act if needed (emphasis added).
  • Future bond purchases, if they occur, will be concentrated in shorter-maturity bonds:  “this effort is going to be focused on the shorter part of the yield curve…so, it’s very different from the prior SMP…falls squarely in our mandate…doesn’t violate the prohibition on monetary financing at all…the focus will be on the short end of yield curve because that falls squarely in the heart of classical monetary policy instruments.  We want to restrict our activity to classical monetary policy.”
  • The heat on governments is not being turned down:  “We want to repair monetary policy transmission channels…but we also know…that monetary policy would not be enough to achieve these objectives unless there is action by the governments.  If there are substantial and continuing disequilibria and imbalances in current accounts, in fiscal deficits, in prices, in competitiveness, monetary policy cannot fill this vacuum, this lack of action.  And so that’s why conditionality is essential.  But the counterparty in this conditionality is going to be the EFSF.  So, action by the governments and by the Euro area is essential for repairing monetary policy transmission channels, as is appropriate action on our side.  That is the reason for having this conditionality.”

A Final Thought

I’m struck by the dissonance between Draghi’s actual words and the way journalists and some money managers interpreted them in the press reports following the ECB press conference.

  • The AP said “European Central Bank President Mario Draghi said Thursday the bank would make a new effort to buy government bonds to drive down the high borrowing rates squeezing the continent’s indebted governments. And he urged leaders of the 17 countries that use the euro to use their bailout fund to do the same.”
  • Bloomberg said “European Central Bank President Mario Draghi said the ECB may wade forcefully into bond markets in tandem with Europe’s rescue fund, stepping up its crisis response despite the reservations of Germany’s Bundesbank.

I’d suggest basing investment decisions on what the ECB actually says rather than on what journalists say the ECB said.

 

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