Shadow Council Mario Draghi's Weak Medicine

Markets widely expect the European Central Bank to take further steps to kickstart the euro zone on Thursday. But many analysts are openly questioning whether Mario Draghi has what it takes to shock the 19-nation currency bloc back to health.
European Central Bank President Mario Draghi at the European Parliament's Economic and Monetary Affairs Committee in Brussels last February.

The markets are pretty clear about what they want to see from the European Central Bank’s meeting Thursday to set interest rates for the euro zone: This time, Mario Draghi has to deliver.

It’s a tall order for Europe’s top central banker, who is fast running out of tools to convince stock markets that he has what it takes to – in the words of one economist – “shock” the European economy back to health.

That’s partly because the European Central Bank’s medicine hasn’t really worked so far. Consumer prices in the 19-nation euro currency bloc fell 0.2 percent year-over-year in February, mainly due to falling oil prices and a weakening global economy. That’s the lowest level in a year, and far below the ECB’s goal of seeing inflation increase by 2 percent.

“The current ECB policy obviously has not worked. The question you have to ask yourself is, in this situation, should we do more of the kind of medicine that has not worked in the past?” said Jörg Krämer, chief economist of Commerzbank and a member of the ECB shadow council, a panel of top European economists convened by Handelsblatt about four times a year.

With the euro zone back in deflationary territory, Mr. Draghi has promised he’ll do what it takes to get the euro zone back on track at the ECB’s rate-setting meeting on Thursday. Markets are widely expecting him to once again cut the central bank’s deposit rate – the rate it charges banks that park extra reserves at the ECB – in a bid to force Europe's banks to lend out more money.

In the eyes of Janet Henry, the chief economist of British bank HSBC, and another member of the ECB shadow council, Mr. Draghi has no choice but to push forward. He can’t afford another disappointment like the one he had in December, when the ECB only slightly eased its monetary policy and sparked a sell-off on global stock markets.

This time, Mr. Draghi can’t hold back: “Given the deterioration in the inflation outlook, this is the time to shock inflation expectations,” Ms. Henry said, adding: “This is an important meeting. He needs to get it right.”

The trouble is that we’ve been here before. This time last year, Mr. Draghi pulled out all the stops. The European Central Bank’s president launched a massive €1.1-trillion bond-buying program, known around the world as quantitative easing.

QE was seen as the bazooka that would finally start pushing inflation back towards the ECB’s target. One year later, inflation is back in negative territory, and top economists are starting to openly wonder whether the central bank has any real power left to move the economy.

“The efficacy of monetary policy … is decreasing rapidly,” warned Andrew Bosomworth, the head of the German division of the major bond investor PIMCO and another member of the ECB shadow council.

The current ECB policy obviously has not worked. The question you have to ask yourself is ... should we do more of the kind of medicine that has not worked in the past? Jörg Krämer, Commerzbank Chief Economist

So what’s the right path forward? The ECB basically has three tools still available. Yet the ECB’s shadow council, a group of leading European economists convened every few months by Handelsblatt, is sharply divided over what Mr. Draghi’s next course of action should be.

The first tool involves cutting rates. Markets widely expect Mr. Draghi to cut the ECB’s deposit rate, which currently stands at -0.3 percent, to as low as -0.5 percent.

Since June 2014, when the ECB became the first major global central bank to cut its deposit rate into negative territory, banks have effectively been charged a fee for parking their reserves with the ECB. While the move is designed to push banks to lend rather than hoard cash, the banks have argued it has cut into their profitability.

Many economists are also starting to wonder whether the ECB might be doing more harm than good. ECB shadow council members polled by Handelsblatt narrowly opposed the ECB cutting its deposit rate any further.

“Negative deposit rates are becoming counterproductive, therefore I would not support an additional cut,” said José Luis Alzola, senior Europe analyst at the Observatory Group.

The move “endangers financial stability because it puts banks’ profitability at risk,” warned Mr. Bosomworth of PIMCO.

Supporters of another deposit rate cut argue there are ways around the banks' troubles. The ECB could for example introduce a "tiered" system, allowing banks to park a certain level of reserves with the central bank before the deposit fees kick in.


Overnight Deposits Held by the ECB-01 (2) euro zone banks negative interest rate


The next tool in Mr. Draghi’s toolkit involves buying more bonds. Since March, the ECB has been buying about €60 billion per month in government bonds and other assets. The idea is to take the bonds off the hands of banks, which can then put the money to other uses.

Most analysts expect the ECB to increase its dose: It could start buying about €80 billion a month, for example. The central bank might also increase the range of assets it buys: It could start purchasing corporate bonds, for example, in addition to government debt.

Economists are skeptical whether this will have a major impact on the euro zone economy too – but it’s still a move that is more broadly favored by the ECB shadow council.

Given the deterioration in the inflation outlook, this is the time to shock inflation expectations. Janet Henry, HSBC Chief Economist

Julian Callow, chief economist of Barclays, said stepping up QE this year is critical to restoring the ECB’s credibility. The central bank needs to send a signal to markets that it will do what it takes to push up inflation in the euro zone.

“It doesn’t really matter if the ECB is buying securities in 2017,” he said, arguing the central bank needs to step up QE now instead and should expand the program by as much as €30 billion a month.

Whether the ECB follows his advice is uncertain. The move is viewed critically among a number of members of the central bank’s own governing council. Part of the challenge is that the ECB is in danger of hitting a series of self-imposed limits: The ECB has said it won’t buy bonds at interest rates lower than the deposit rate, nor will it buy more than 33 percent of the bonds of any one country.

If the ECB expands its program, it could reach these limits before the program is supposed to come to an end in March 2017. Some therefore expect the ECB might only increase the monthly volume for about six months.



The ECB’s third and final tool? The central bank could expand a program of lending cash directly to banks at cheap rates. The ECB could, for example, offer three- or four-year loans at 0.05 percent interest.

Expanding the ECB’s liquidity program is also a move favored by most economists, even though most acknowledge it won’t have any major impact beyond a few troubled banks in the euro zone. Most banks don’t really need extra liquidity – the trouble has been that banks don’t know who to lend the money to.


Jan Mallien covers monetary policy for Handelsblatt in Frankfurt. Christopher Cermak covers the economy and finance as an editor for Handelsblatt Global Edition in Berlin. To contact the authors: [email protected] and [email protected]