Extra mild ECB tapering of QE and zero interest rates keep euro low

European Central Bank President Mario Draghi (on the right) and Vice-President Vítor Constâncio prepare to take positions for the customary Press Conference after the meeting of the Governing Council. (Taken on October 26, 2017. ECB photo; some rights reserved ).

Last Thursday, Mario Draghi, the President of the European Central Bank performed again his superb balancing act, between the needs of the South and the demands of the North. He led the Governing Council of ECB, Eurozone’s most powerful body, to map the exit road from the extraordinary monetary measures (Quantitative Easing) state as frictionlessly as possible. He halved the monthly money printing as Germany demanded, but extended the program by nine months. He also kept the basic interest rate at its present zero level as the South needs, “for an extended period of time, and well past the horizon of our net asset purchases”, as he clearly stated. Let’s dig into the details.

As from January 2018, the ECB will be printing and injecting €30 billion a month into Eurozone’s financial system instead of €60bn currently. However, Draghi affirmed the money printing will be extended by nine months until September 2018. He rushed to add also that it may be prolonged even further, “if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim”. To be reminded, ECB’s inflation target is set at close but below 2%, while it currently oscillates around 1.3% well below the target.

Jammed inflation

Persistently low inflation is haunting the Eurozone for years, despite the fact that the economy is growing for 17 quarters in row and unemployment has fallen close to pre-crisis levels. Yet, despite all that, and the €2 trillion the ECB has printed and injected into the economy, the rate of change of the consumer price index remains stuck at very low levels for a very long time.

By the same token, inflation forecasts for the medium term still see it below optimum levels. There are many reasons for this, but according to many analysts the most important among them is that the wage negotiations and agreements between unions and employers are based on past very low inflation figures.

Between North and South

Coming back to what Draghi announced last Thursday, it must be stressed that he efficiently tiptoed between the needs of the south and the demands of the North. Italy, Spain, Greece, Portugal plus France and Ireland need very low interest rates and a rather undervalued euro. On the contrary, Germany mainly vies for a substantial interest rate being paid on deposits, because this country is the definition of the ‘moneybag’. Her hoarded reserves exceed 1.5 trillion. Only last year Germany had a net trade surplus of around €300bn.

The South needs low interest rate and a cheap euro in order to refinance its mounting debts and support growth of the real economy. During the past months just the expectation about the ECB was planning to cut down the monthly money printing, had strengthened the euro versus the dollar. Eurozone’s single currency was trading at 1.05 dollars last spring and reached this autumn 120 American cents, penalizing the South.

Arresting euro’s hike

Nevertheless, the ECB knew it had to cut down, by the end of the year, its overblown quantitative easing program, and the strengthening of the euro was an inevitable side effect. In view of that, Draghi wanted to do it gradually. It was his strategy to let the money market gradually discount the upcoming policy changes all along this summer. His hints were so clear up to the point the actual announcement of the policy changes last week had the opposite effect. The exchange rate between the two monies fell from 1.19 on Wednesday to around 1.16 on Friday.

Draghi proposed another equally important measure which Governing Council accepted. That was the full reinvestment of the cash from maturing bonds the ECB has cropped and continuous hoarding. He said “the Eurosystem will reinvest the principal payments from maturing securities purchased under the Asset Purchase Program for an extended period of time after the end of its net asset purchases, and in any case for as long as necessary”.

No end to QE?

It must be clarified here that all along the quantitative easing period of the past two years, the ECB has accumulated a net worth of assets of more than €2 trillion under the APP. The bank will continue buying new assets of €60 billion a month until December and then €30 billion monthly from January to September 2018. As a result, at the end of September next year the ECB will be holding anything around €2.5 trillion in government and corporate bonds.

Of course, all along the past two years the ECB apart from the €60bn a month was also acquiring new bonds of a value more or less equal to assets which matured and were cashed. It was not clear though if the ECB was to reinvest the full amount of maturing assets, after the APP is terminated.

Draghi made a lot of efforts last week to clarify that whatever bonds mature of this unbelievable pile of €2.5tn in assets, the ECB will use the cash received to buy other bonds of an equal value and thus reintroduce the cash into the economy. This practice will continue “for an extended period of time after the end of its net asset purchases” and he said Eurozone needs it to keep on growing. In short, the ECB made clear, it will not cut down the amount of euros injected in the financial system, and the economy will continue being favored by a net wealth of extra cash of €2.5tn in the foreseeable future.

Keeping Eurozone liquid

Vítor Constâncio, Vice-President of the ECB said the monthly amount of reinvestments may vary around €10bn a month. Investors will be informed about the exact figure two or three months in advance. This clarification had a strong impact on the money markets. It became clear Eurozone’s liquidity will be maintained at even higher levels than today in the foreseeable future. That’s why the foreign value of the euro decreased at the end of last week and the parity with the dollar fell. It would have been the opposite, if Draghi hadn’t taken those additional measures, when announcing the tapering of the quantitative easing.

Last but not least, Draghi revealed there was a consensus in the Governing Council about all those monetary policy changes. The only case where there was ‘just’ a large majority was if “an end date should have been announced or not” about the whole program. Not much thinking is needed to understand it was Germany asking for an end day to be set. And Draghi concluded “…the large majority of the Governing Council members preferred to keep it open-ended”.