Draghi’s Hesitation

In a Hearing at the European Parliament’s Economic and Monetary Affairs Committee, ECB president Mario Draghi said the “ECB will Not Hesitate to Act“.

In December, Draghi disappointed the market by cutting interest rates to -0.3%. Keynesian and Monetarist economists (who are themselves part of the problem) say Draghi did not do enough to boost ECB asset purchases and/or the ECB did not cut rates negative enough.

Since December, Draghi has twice given speeches promising further action. However, talk is cheap. By not doing anything but instead yapping about it twice, Draghi has already hesitated.

Draghi Speech Excerpts

In order to make the euro area more resilient, contributions from all policy areas are needed. The ECB is ready to do its part. As we announced at the end of our last monetary policy meeting in January, the Governing Council will review and possibly reconsider the monetary policy stance in early March. The focus of our deliberations will be twofold. First, we will examine the strength of the pass-through of low imported inflation to domestic wage and price formation and to inflation expectations. This will depend on the size and the persistence of the fall in oil and commodity prices and the incidence of second-round effects on domestic wages and prices. Second, in the light of the recent financial turmoil, we will analyse the state of transmission of our monetary impulses by the financial system and in particular by banks. If either of these two factors entail downward risks to price stability, we will not hesitate to act.

Health of Banks

In regards to the health of European banks, Draghi opted for a whitewash of the problems.

We have to acknowledge that the regulatory overhaul since the start of the crisis has laid the foundations for durably increasing the resilience not only of individual institutions but also of the financial system as a whole. Banks have built higher and better-quality capital buffers, have reduced leverage and improved their funding profiles. … central bank governors and heads of supervision indicated that they are committed to not significantly increase overall capital requirements across the banking sector.

There is a subset of banks with elevated levels of non-performing loans (NPLs). However, these NPLs were identified during the Comprehensive Assessment, using for the first time a common definition, and have since been adequately provisioned for. Therefore, we are in a good position to bring down NPLs in an orderly manner over the next few years. For this purpose, the ECB’s supervisory arm is working closely with the relevant national authorities to ensure that our NPL policies are complemented by the necessary national measures.

Return of the Financial Crisis

The market does not believe Draghi on the health of European banks and neither do I.

Financial Times writer Wolfgang Münchau discusses Four Signs Another Eurozone Financial Crisis Looms.

The rout in European financial markets last week was a wat­ershed event. What we witnessed was not necessarily the beginnings of a bear market in equities or an uncertain harbinger of a future recession. What we saw — at least here in Europe — is the return of the financial crisis.

The European Central Bank has missed its inflation target for four years and is very likely to miss it for years to come.

The financial markets are telling us that they are losing faith in Mario Draghi’s pledge of 2012 when he promised to do “whatever it takes” to defend the member states of the eurozone against a speculative attack. With this promise the ECB president ended the first phase of the eurozone crisis, but did so at a cost. The urgency to resolve the underlying structural problems suddenly disappeared.

It is no coincidence that bank share prices collapsed just as the European Bank Recovery and Resolution Directive entered into full force. The directive sets out a common bail-in mechanism for a failing bank. Italy applied this law last year in the bailout of four regional banks, causing losses to bondholders. Investors in other banks fear that they, too, may be bailed in. One of the reasons why investors in Deutsche Bank began to panic last week has been the large amount of contingent convertible bonds (cocos) issued by the bank.

The third message is the market ex­pectations of future inflation have suffered a permanent shift. The ECB is taking market-based estimates of future inflation seriously — perhaps too seriously. Its favourite metric is an inflation rate for a horizon of five to 10 years away from today. That measure last week fell to its all-time low of just over 1.4 per cent. It is telling us that the markets no longer believe that the ECB will hit its inflation target of less than 2 per cent even in the long run.

The fourth message is that the markets fear negative interest rates. This is because the vast majority of Europe’s 6,000 banks are old-fashioned savings and loans: they take in deposits and lend them out. The banks would normally adjust the rates they offer to their savers in line with the rates the ECB charges them, maintaining a profit margin between the two. But if the ECB imposes a negative rate on the banks, this no longer works. If the banks im­posed negative rates on savings accounts, small savers would take their money and run. The banks could, of course, reduce their reserves at the central bank and lend the money instead. Or they could invest in risky securities. But that prospect is not necessarily reassuring to bank shareholders either, especially if they do not see good lending and investment opportunities.

Deer in Headlights

Draghi is like a deer in headlights not knowing which way to turn. I agree with Münchau’ suggestion the “markets fear negative interest rates”. Rather than the implied message “Draghi did not do enough”, the real message may very well be that Draghi has done too much of the wrong thing.

Were the Fed, to implement negative rates, it would destroy money market funds immediately. Yet, the Fed is studying the idea.

Negative Results

Fed Uncertainty Principle

It’s time for a review of the pertinent points of the Fed Uncertainty Principle. The principle and the corollaries apply to central banks in general, not just the Fed. In the corollaries below simply replace the word “Fed” with your central bank of choice.

Corollary Number One: The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three: Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Fear of the Guess

The only thing central banks know how to do is blow bubbles of increasing amplitude over time.

Central banks never see the consequences of their actions, and now they are stuck once again guessing at what to do.

Draghi has not taken further action because he is clueless about what to do. Meanwhile, Draghi and Yellen talk, each hoping the problem will go away, but it won’t. There are no winning central bank actions.

Mike “Mish” Shedlock