Dig Deep

European Central Bank (ECB) President Mario Draghi cemented his legacy as defender of the euro by delivering a parting gift at his penultimate meeting.  The ECB cut its deposit rate by 10bps to negative 0.50%, introduced a two-tiered rate system and will restart its quantitative easing (QE) program on November 1. In addition, a new targeted longer-term refinancing program was introduced to “preserve favorable bank lending conditions”.

The relatively modest size of QE (€20 billion per month, but open-ended), less than what the market was expecting, came on the back of a broad consensus but not unanimity. Several policymakers, including central bank leaders from Germany, France and the Netherlands, had articulated displeasure over the relaunch of bond purchases. A more modest program also avoids the challenge of changing rules as to how much of each country’s debt the ECB is allowed to own.

There were other reasons for not firing the monetary policy “bazooka” just yet. The eurozone economy is in better shape today than it was in early 2015, when the ECB introduced QE.  The service sector remains resilient, with no clear signs of stress. The labor market continues to tighten, with wages trending up.  Though still low, there are signs inflation is building: the less volatile, business cycle-driven ‘supercore’ inflation measure is trending up. Furthermore, short- and long-term interest rates are low, driving strong credit growth.

That said, there were enough reasons to act.  Germany is close to a recession, the region’s industrial sector is in a precarious state, the threat of a disorderly Brexit still looms and the prospects for the world economy (particularly China) are dimming amid trade tensions. A collapse in market-based measures of inflation expectations could bring back the threat of deflation.

There are certainly those who question the effectiveness of additional monetary stimulus. It will be difficult for the central bank to compensate for restrictive trade policy. With both short- and long-term rates already at historic lows, it is hard to see pushing them lower will help. And fiscal policy is a constraint. Draghi emphasized the need “for fiscal policy to take charge,” adding that “governments with fiscal space should act in timely and effective manner.” That last statement seemed squarely aimed at Germany.

Nonetheless, the “strengthened state dependent forward guidance” used by the ECB this week did move markets. Interest rates and the euro fell after Thursday’s announcement, as Draghi successfully communicated the intent to remain aggressive for a much longer period of time. A weaker euro might provide some boost to inflation at the cost of consumer spending, but with other central banks following suit, any benefits would be short-lived.

The implementation of a tiered reserve system allows banks to exempt some of their deposits from negative rates. A number of institutions continue to offer positive rates to retail savers, on which they are losing money. The tiering is designed to remove what is essentially a tax on banks, which some have suggested is impairing lending in the eurozone. The tiering system is likely to benefit banks with large deposits, mainly concentrated in core member nations.

Draghi’s farewell package has paved the way for his successor (Christine Lagarde) to have a smooth start.  Seven years ago, he promised to do whatever it takes; in the years since, he has done everything he could.