ECB disappoints, thankfully

5 min read

In an underwhelming policy decision on Thursday, the European Central Bank managed both to avoid a more severe policy mistake and disappoint the market.

That is what I call killing two birds with one stone.

Deflating expectations of more, the ECB cut its key policy rate by just 10bp, to -30bp, while extending and broadening its campaign of buying bonds.

This was less than the market expected, and equities in the eurozone sold off by roughly 3.5% while the euro rose sharply in value.

While no one could produce a note from the ECB promising the pony the market felt it was due, that was the spirit of the reaction.

In one respect, the ECB’s decision to cut by only 10bp was good, as the further into negative territory it takes interest rates, the more difficult lending conditions become for the banks upon which the eurozone must rely.

“What ails Euroland — the reason the economy cannot grow fast enough to push up the rate of core CPI increases toward the 2% target — is a dearth of bank lending,” Carl Weinberg of High Frequency Economics wrote to clients. “The credit crunch is caused by capital shortfalls in the banking system, relative to an ever-rising regulatory capital adequacy bar.”

Banks in the eurozone have a two-fold problem; they need capital and they must lend at profitable margins. Central bank liquidity and negative interest rates do little for the first and are actually harmful to the second.

In Switzerland, which has had interest rates of -75bp since January, mortgage rates have actually risen, as banks found that their cost of borrowing did not fall as rapidly as government borrowing rates.

The ECB extended the types of bonds it would buy to include state and municipal debt, necessary in part because its €60bn per month pace of buying is rapidly eating through the universe of eligible eurozone sovereign debt.

The ECB may have missed an opportunity here. Had it expanded its purchases to include the riskier types of bank loans now clogging balance sheets, it would likely have had an impact on current lending.

Communications can’t trump reality

The so-called communications problem of the ECB, defined as “surprising” the market, is real, but is predicated on infantile expectations. There are divisions within the ECB over policy, a secret to no one who reads speeches of its policy-makers. The communications problem instead is that the markets expect that it will be promised what it wants, and that the package will always arrive on time.

While transparency in central banking is a good thing, central bankers cannot rearrange the world and events to suit what they have said in the past. ECB chief Mario Draghi’s heroics during the euro crisis may have given him rather more credibility, of a credulous kind, in financial markets than is good either for him or them.

Things change, and so does policy. Forward guidance, therefore, is bad parenting practiced on willful children. It keeps them quiet, perhaps, but at considerable costs, both long and short-term.

The ECB said earlier that the deposit rate had hit its lower bound, but reversed course to argue that deeper cuts by other central banks and a decline in market rates meant it had more room. Well, perhaps less than it thought it did, but there is no crime in being wrong, only in persisting once you know you are.

If we look at the marginal costs to the economy of the ECB disappointing, they are surely not that great. The choice is between suffering volatility as the market adjusts to reality, or living with the policy errors that sticking with earlier promises implies.

There has been a world-wide drive among central banks, notably the Fed, to improve transparency, but this gets conflated with not shocking markets. There were good reasons during the financial crisis for central banks to want to keep markets calm.

The farther we get from a crisis state and the more we seem to be settling into a swamp of very low inflation and muted growth, the less compelling those reasons are.

The problem, ultimately, with the cult of central bank credibility, is that it gets defined down, not to mean meeting one’s objectives in terms of employment and inflation, but delivering what the market expects.

The ECB can do better than that, and shouldn’t worry too much about Thursday’s market upset.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

James Saft