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While analysts have been clamoring over a monetary policy decision from the Federal Reserve today, the more important decision will come from the European Central Bank tomorrow.The ECB Governing Council will meet in Frankfurt to discuss the bank’s latest policy action on Thursday, and according to Lorcan Roche Kelly, Chief Europe Strategist at Trend Macrolytics, there’s one way to know that the ECB will massively disappoint:
If it cuts interest rates when the decision comes out at 7:45 AM ET.
Roche Kelly argues that Draghi has admitted that monetary policy alone is not working amidst strains in the European financial system. Indeed, the central banker remarked on this problem last week—a piece of his momentous “do whatever it takes to preserve the euro” speech to London bankers last week.
Draghi admitted, “The size of these sovereign premia hampers the functioning of the monetary policy transmission channel.”
Sovereigns’ high borrowing costs (particularly Spain and Italy) translate into high borrowing costs and harsher haircuts on collateral for commercial banks. Spanish banks hold high levels of Spanish sovereign bonds and face difficulties using them as collateral when the bonds cost dramatically less than German bunds, for instance. In addition to these collateral troubles, these banks also face negative speculation from investors worried that banks will have to take write-downs on these assets.
This means that traditional monetary policy—meant to incentivise lending—doesn’t work because it cannot alleviate concerns about the viability of governments, institutions, and lenders.
If Draghi continues to revert to monetary policy measures that he’s already admitted do not work, however, this will be a sign that he and the ECB are still unwilling to take stronger measures to bolster the European financial system. A rate cut would serve as a concession to markets, but would ultimately prove useless.
Given Draghi’s comments lately, such a rate cut appears improbable. Roche Kelly told Business Insider that the ECB will most likely restart its bond purchasing program (SMP) in an effort to hold sovereign bond borrowing costs down until September. This would allow European leaders to take their August vacations, believe it or not an important signal to markets that they are not worried Europe will come unhinged.
More importantly, such a move would allow Draghi to maintain pressure on EU leaders to take the steps he’s been hinting at lately while at the same time propping up the European economy in the short-term.