Draghi’s 2018 compromise: enough money printing to revive inflation and check euro ascent

European Central Bank Press Conference in Frankfurt am Main, Germany- 7 September 2017. ECB President Mario Draghi (on the left) and Vítor Constâncio, ECB Vice-President walk to the Press Conference room.( ECB audiovisual services. Some rights reserved).

Last Thursday Mario Draghi, the President of the European Central Bank, reassured the Eurozone banking conglomerates they will continue being blessed with zero cost money, well into the foreseeable future. He stated, “one thing is clear; the bottom line is that interest rates will stay, as it’s written here, at the present levels (zero for main refinancing operations) for an extended period of time and well past the horizon of our net asset purchases”. In short, Draghi reassured the bankers in the most serene and affirmative manner, that in the medium term they will go on pocketing a large part of the wealth the rest of the economy produces. All Eurozone bankers must have rejoiced at this.

Apart from that, Draghi said the October ECB Governing Council will decide about the future of central bank’s monetary policy, most probably ready to taper the extraordinarily expansionary monetary measures. Presently, the ECB prints and distributes €60 billion a month, through purchases of bonds held by Eurozone commercial banks. Officially, this policy expires in December; however the ECB has to inform in advance the markets about its intentions, under the ‘forward guidance’ principle.

Forward guidance for bankers

Under this light, the ECB is expected to announce in October its intensions to apply a tighter monetary policy. During the past few months, the money markets have been discounting this future policy change and consequently the euro has markedly appreciated with the dollar. Actually, last Thursday, after Draghi confirmed the ECB is to reset its monetary policy in October, the money market catapulted the euro above the 1.20 benchmark with the dollar, the highest level for two and a half years. The euro has gained more than 14% this year in comparison to the American money.

Yet, the core mandate of the ECB doesn’t relate to targets like the euro parity or economic growth or even unemployment. The Eurozone central bank is solely authorized to pursue price stability and take the necessary measures to bring inflation close but below to 2%. Now, the strengthening of the euro makes the prices of imports cheaper and as a result it further suppresses headline inflation. To be reminded, during the past seven years, the ECB has being trying to revive the dying inflation rate, which was found by Eurostat at 1.5% in August.

Stronger euro

The strengthening of the euro though undermines ECB’S efforts to bring inflation close to 2%, and Draghi said that “the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability”. In short, the Governing Council is deeply concerned about the visible negative effects on inflation, from a rising euro.

Understandably, the single currency will continue appreciating, if the central bank tapers its extraordinary monetary policy, by reducing or even zeroing the monthly €60 billion it injects into the financial system. Under the present expansionary pact, the ECB has infused into the economy €2 trillion during the past two years.

Is more needed?

The continuation of the same strategy though and the complete deferring of tapering may gravely distort the entire economy. Continued stocky money injections are to create bubbles in markets like the real estate and public borrowing, or lead the entire financial system to dangerous “excessive optimism, leverage, and maturity transformation”. The American central bank has stopped printing and circulating new dollars since November 2016, on similar hazards. Undoubtedly, then, the ECB is to taper next month, but the question is how much? Let’s dig on that.

All and every financial market expects that the ECB is to reset its policy lines in October. Last Thursday, the euro reached a two and a half year high after Draghi said, “the bulk of these decisions will be taken in October”. The fact that he set a precise time point to announce the new policy lines, indirectly created a certainty in markets, that the ECB will surely change something as from January next year, towards the orthodox side. Not to forget, the ECB is obliged to caution the markets in advance about its intended major policy changes, under the ‘forward guidance’ principle.

A tradition of compromise

However, if one paid careful attention to what Draghi said last Thursday, one can come to conclusions about the broad lines of the new 2018 ECB policy. For one thing, interest rates will remain unchanged and the Eurozone banks will continue being favored by zero refinancing interest rates. As for the monthly injections of newly printed euro, they will be reduced but not much below today’s level of €60bn. To revitalize inflation and achieve the target, enough new printed money is needed. Draghi hinted at this when he said, “Now, the other topic we discussed was basically the calibration of our policy instruments starting with next year”. This certainly means there will be a compromise between an inevitably stronger euro, a development which will result even from the smallest tapering, and of course the targeting of increased inflation.

The President of ECB in his introductory remarks clarified his intentions on that field by saying “Therefore, a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term”. In other words, in 2018 the monthly money printing will be rather close to the currently €60bn a month, in order to help inflation rise, while keeping the euro appreciation at bay. A too strong euro could further distress all the deficitary Eurozone countries, including France, and Draghi won’t allow that to happen.