A lack of tangible action from European Central Bank President Mario Draghi yesterday sent markets hurtling downward.Today, however, they’ve rebounded after some analysts realised there was an upside to the remarks.
The importance of Draghi’s comments may not have been what he said, but how he said it.
Draghi set forth criteria that EU political leaders must abide by in order to receive monetary policy assistance, while at the same time promising that EU countries like Spain and Italy won’t fail in the short term.
In other words, he sent the following message: “If you do that, then I will do this.”
This is a divergence from earlier policy, which was unpredictable and reactive.
For example, the ECB revved up its bond purchase program (SMP) last summer only once tensions in Europe neared unbearable levels. The move felt rushed and panicked, nobody trusted it, and so it became less of a bazooka and more of a squirt gun.
Even the central bank’s more effective three-year long-term refinancing operations (LTROs)—two massive liquidity operations that stoked bank lending and pulled down borrowing costs—came as a surprise to investors. They only believed Draghi might be using his leverage to force European leaders to action after the fact.
Now, however, Draghi is clearly spelling out his demands and the rewards, somewhat tyrannically forcing EU leaders to move forward.
This diminishes some uncertainty in the real economy. The ECB will purchase shorter-term debt and attempt to push down the front end of the yield curve. EU leaders will resolve concerns about official sector creditors as de facto senior bondholders and they will start using the European bailout funds to purchase sovereign bonds.
Not to mention that the central bank has also confirmed it will make reducing sovereign borrowing costs (at least at the short end) a matter of clear policy.
Draghi is essentially holding a bullet to the heads of country leaders, explicitly refusing to do anything beyond preserve the situation until EU leaders earn the long-term reward.
By focusing SMP on shorter term end of the yield curve, ECB will indeed lower shorter-term borrowing costs for Italy and Spain (3-5 year max maturity), while steepening 10 year instruments costs to discourage, relatively, longer term borrowings. This means Italy and Spain should get an added incentive – growing over time as overall maturity profile of their debt starts to shorten as well – to enact long-term reforms. At the same time, ECB will be buying (assuming it does go through with the threat) shorter-term instruments, implying that unwinding these assets will be a natural process of maturity. ECB will not commit to sacrificing long-term flexibility of its policy tools by expanding SMP on the longer end of the yield curve, thus reducing overall risks to the monetary policy in the future.
These latest moves show that Draghi has European leaders over a barrel. The ECB has typically been more proactive than EU leadership, and this amounts to little less than a power play.
That’s not to say that these latest announcements will necessarily be good for financial markets. Draghi’s plan confirms that he will push EU leaders to the brink before he does anything, and such pressure typically leads to losses in equities.
However, in the real economy, Draghi’s promises to act are invaluable. Such clarity could give investors faith enough to invest in the real economy, despite continued volatility in the markets.
This tyrannical but—for now—positive structure does have one fatal flaw, however. Should Draghi underestimate market angst and should EU leaders fail to deliver appropriate reforms in time, the ECB chief will have to wage a speedy retreat to save the financial system even without his demands fulfilled.
Thus, there’s chance that EU leaders could call Draghi’s bluff.