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The European Central Bundesbank or the ECB at the Rhetorical Zero Bound

Posted by Joseph Trevisani on Apr 7, 2014 12:25:00 PM

European Central Bank President Mario Draghi's is discovering that his great success two summers ago in defeating the dissolution of the euro is not an effective template for the more mundane problems of central bank policy. 

Mr. Draghi's famous promise that July, at the height of the euro zone debt crisis, to do "whatever it takes" to save the euro was eminently credible. If the euro zone had collapsed the entire economic and political structure of Post- World War Two Europe could have fragmented.

The Outright Monetary Transactions program outlined was unworkable. It could not even begin until a country had asked and accepted a rescue plan, by which time the sovereign debt markets of that country’s bonds would have crashed.

Even though asset purchases were and still are opposed  by Germany, the gravity of the situation and the belief by the markets, forcefully expressed by Mr. Draghi, that the Europeans would save their financial and economic system was enough. Mr. Draghi's rhetoric served and the crisis was averted. The central fact to his success was credibility. 

Proof can be found in the reaction of the sovereign debt markets. For example Spain. Though Spanish economics and finances did not appreciably improve over the next eighteen months, the yield on the country’s 10 year bond fell from 7.27 percent on July 20th, 2012, to 5.63 percent early that September and to 4.04 percent in May of last year.

A six week rally then brought it back to 4.91 percent from where it has since fallen to 3.18 percent. The current rate is more than a point lower than the 4.25 percent average for the decade before the debt crisis erupted at the end of 2010. According to the credit markets Spanish debt is now safer than at any time since the financial crisis.

If Mr. Draghi and the ECB can be so effective in the very difficult and uncharted circumstances of a sovereign debt crisis, why is the bank's rhetoric so inconsequential now?

The answer is, once again credibility. In 2012 Marico Draghi had a great deal.  Now for two reasons, he has very little.

The European Central Bank would prefer a lower euro. Mr. Draghi said as much at the last policy news conference.

The ascendant euro makes export life difficult for every member of the EMU, Spain, Greece, Portugal, France and even powerhouse Germany.

Since July 2012 the euro has gained 14 percent against the dollar and a remarkable 50 percent versus the yen. Such currency strength adds one more burden to a continent struggling with moribund economic growth, record high unemployment and in many countries a shrinking work force.

The main policy rate in the euro zone is 0.25 percent. That is the effective zero bound, where further reductions have little or no effect on monetary or economic conditions.

When the U.S. and the Federal Reserve reached that limit the bank plunged ahead with its various quantities easing programs, the last of which is still running. The economic success of QE is debatable. What is not debatable is its effect in weakening the dollar which has worked in concert with the ECB’s success in ending the debt crisis.

Over the past six months Mr. Draghi and other European Central Bank officials have mentioned the banks supposed 'toolkit' for alternative monetary policies many times. Negative interest rates, suspension of debt sterilization and asset purchases are all purported to be under consideration.

But despite numerous comments the governors have done nothing. Even the weekend news story outlining an ECB study of quantitative easing, which showed that the printing of one trillion new euros would raise inflation by 0.8 percent fell unheeded.

The ECB has reached its own rhetorical zero bound, where no amount of talk will produce a result unless backed by action.

Mr. Draghi’s second problem is that the Bundesbank, the German central bank, has not spoken with one voice. Despite having at various times endorsed the ending of debt sterilization and negative interest rates, while remaining adamantly opposed to assert purchases, there is doubt that even those accommodations are  secure.

This past week Jens Weidmann, the bank President, said that he hadn’t changed his view on asset purchases. This contradicted Mr. Draghi's assertion that ECB policymakers are considering various policies, including those asset purchases. 

Mr. Weidmann also stressed the need for EU countries to continue their fiscal and economic reforms and said that monetary policy cannot solve the financial crisis.  Presumably one of the problems monetary policy cannot solve is deflation. This does not sound like a policy maker giving approval to Mr. Draghi’s venturesome ideas.

The Bundesbank retains an unofficial veto over ECB policy. There is no certainty that the Germans have agreed to any of the measures that the ECB and Mr. Draghi have been talking about for so long. As long as that doubt remains, ECB rhetoric will likely be moot.

Joseph Trevisani

Chief Market Strategist

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