European Central Bank (ECB) governor Mario Draghi recently held his penultimate monetary policy meeting before he hands over to Christine Lagarde (formerly at the International Monetary Fund). Markets had hoped for fireworks from the man widely viewed as having “saved the eurozone” at the height of the sovereign debt crisis in 2012. So did he deliver? As expected, Draghi cut interest rates from –0.4% to –0.5%. He also restarted quantitative easing (QE). The ECB will buy €20bn of eurozone sovereign bonds every month, with no end date – the purchases will continue until the ECB is ready to raise interest rates again, which may be a while.
The market and press reaction was muted. In the Financial Times, Laurence Fletcher reported “a growing acceptance that monetary policy has reached its limits.” And the sense that resistance is growing to easy monetary policy wasn’t helped by a front page on German newspaper Bild, accusing “Count Draghila” of sucking savers dry.
Yet Draghi may have achieved more than we think. Firstly, notes Eric Lonergan of M&G on his Philosophy of Money blog, the ECB didn’t just cut rates and reactivate QE. It will also allow commercial banks to deposit more of their reserves with it at 0%, rather than charging them –0.5%. Why does this matter? It means banks can borrow funds at negative rates from other banks with excess reserves, and then deposit these with the ECB at 0%. That means they make a risk-free profit (and this comes on top of the TLTRO scheme – see below – which allows banks to borrow at as little as –0.5% to lend to the “real” economy). As far as Lonergan is concerned, “if legal, the limits to monetary policy have just been lifted… official interest rates are now having the net effect of transfers to the private sector.” If so, the implication is that fears that eurozone banks will collapse are overblown, removing a key source of the market’s current deflationary angst.
Secondly, as Cedric Gemehl of Gavekal notes, under “QE Infinity”, the ECB will buy more sovereign debt than eurozone governments plan to issue next year, while keeping interest rates nailed down. That means all eurozone countries will be free to spend more money without breaking the European Union’s fiscal rules. In other words, Draghi has made it as easy as he possibly can for eurozone governments to turn to fiscal policy, a line that Lagarde is also certain to push.
I’m not sure I’d buy eurozone banks yet. But if Draghi has put a floor under the sector, and given governments free rein to spend, it’s another sign that markets are betting on deflation too aggressively – and not paying enough attention to the risk of inflation.
I wish I knew what a TLTRO was, but I’m too embarrassed to ask
Targeted Longer-Term Refinancing Operations (TLTRO) are one of the “unconventional” monetary policy tools used by the European Central Bank (ECB). The ECB agrees to lend money to commercial banks over a set period at a very low rate, on condition that they lend this money out into the “real” economy (by making loans to businesses, for example). The point is to give banks a cheap source of funding that they are encouraged to lend out, in order both to raise bank profit margins and to boost economic activity and growth.
The first tranche of TLTRO loans was launched in June 2014, with a second batch following in March 2016. The third tranche was launched in June this year, and began in September. Initially the plan was that banks would be allowed to take out a two-year loan, at a rate based on the ECB’s average rate plus 0.1% (with the loan getting cheaper, the more the bank lends out).
However, the rate on the loans was lowered this month as the ECB’s views on future growth deteriorated (thus justifying a move to even looser monetary policy). Meanwhile, the loan period was lengthened to three years, with a repayment option at two years. In other words, the banks will be able to access funds at a lower rate, and for a longer period of time, than before, which should boost the profitability of any loans the banks make.
Indeed, as strategist Tom Kinmouth of ABN Amro put it, the move resulted in banks benefiting from terms that were “considerably better” than previously planned – “they can now borrow from the ECB… as low as –0.5%”. In other words, “the ECB will pay banks to take money.”
Of course, making money available to banks to lend is a very different matter to finding businesses and individuals who are keen to borrow the money. Some argue that cheap funds haven’t driven growth higher because central banks are now “pushing on a string.”