ECB: Draghi's grand finale!

Background

The ECB was widely expected today to tackle the problems of sluggish growth, low inflation and plummeting expected inflation. Philip Lane, who became the ECB's new chief economist in June, wanted to stem the tide through a combination of measures since “the instruments were designed to be complementary and mutually reinforcing.” The president, Mario Draghi, also seemed to share this view. However, some presidents of national central banks, including heavyweights, were sceptical, not wanting to drop all their ammunition at once.

Three main instruments and multiple possibilities:

·         The deposit rate: this is the rate at which commercial banks deposit their cash with the central bank. This rate has been negative since June 2014. So banks are paying to place their cash (€7 billion in 2018).

·         The tiering system: this would relieve the banking system, which has been weakened by the negative deposit rate. It is a question of creating several tiers, as is the case in Switzerland, Denmark and Japan. Each tier has a corresponding rate. Thus, banks would pay a smaller sum than they do today (0.40% on all the sums they deposit with the central bank).

·         Quantitative Easing (QE): an asset purchase programme. The previous one, which included the purchase of government and corporate bonds, ended in December 2018.

The decision

The Monetary Committee finally followed the recommendations of its president and chief economist. A broad set of measures to shore up the economy was announced, although some small details disappointed the markets.

·         The deposit rate was cut by 10 basis points to -0.50%, which slightly disappointed the markets, which had discounted a cut of 15 basis points. The ECB, however, leaves the door open for more downside if necessary.

·         The ECB is introducing a Swiss-style tiering system in order to soften the blow of negative rates.

·         The ECB promises not to raise rates until inflation expectations come close to the 2% target. It will no longer give a specific date for raising interest rates.

·         The ECB is launching a new QE programme, admittedly a little less ambitious than the markets had expected (asset purchases of €20 billion per month, compared with the €30 billion expected), but with no end date! The details have not been revealed, but presumably, it would concern government and corporate bonds.

·         The ECB is easing the parameters of TLTROs (ECB loans to banks) by lowering rates and lengthening maturities from 2 to 3 years. Banks lending to the real economy will therefore be able to benefit from rates as low as -0.50%.

The ECB is pushing its monetary instruments to their limit. There is still some room for manoeuvre on rates thanks to the introduction of a tiering system. QE will function for several more months, but will then run up against the limits that the ECB set itself (not to hold more than 33% of a bond issuance in order to mitigate the risk of it becoming a dominant creditor of euro area governments). By raising this limit, QE will be able to continue for several years. TLTRO rates have been cut, but credit demand is not dynamic enough today.

Once again, Mr Draghi is calling for more fiscal policy to prop up the economy. No doubt, Christine Lagarde, who will succeed Draghi on 1 November, will share this opinion.

Initial market reactions

Long-term bond yields have eased sharply. The yield on the German Bund has slipped below -0.60%. The peripheral countries have benefited most from the announcements: Italian, Spanish, Portuguese and Greek yields are falling significantly. The Italian 10-year yield has hit an all-time low of 0.78%.

Corporate bonds are also appreciating thanks to the QE announcement.

Equity markets are bouncing back. The banking sector remains in balance, on the one hand welcoming the tiering system, but on the other, cushioning the fall in long-term bond yields.

The euro is depreciating against the dollar, to 1.095 from 1.10.

The 5-year inflation swap rate, which measures forward inflation and therefore the credibility of the central bank, has stopped falling and has risen from 1.22% to 1.31%.