I googled “no-win situation” the other day, and the computer spit out a picture of ECB President Mario Draghi. I actually feel sorry for the guy. Although he understands the severity of the deflationary spiral that has engulfed Europe, the constraints of the European Union make it illegal for him to take the necessary actions. The Germans are insistent that the debt not be monetized. Although Draghi has valiantly fought for the right to execute various forms of quantitative easing, it has been a long uphill battle.
And herein lies the problem. The markets understand that Draghi has limits in his ability to reflate. So although they are scared about what he might do in the short run, over the long run they are going to simply discount his actions and return to pricing in the deflationary vicious circle.
Remember PIMCO’s Paul McCulley’s argument that to stop deflation the Central Bank needs to be “responsibly irresponsible?” Well, he actually took that from a Paul Krugman paper and although it loathes me to say this, I find myself agreeing with the cat loving bearded one.
From Paul McCulley’s article titled “What if”:
In the midst of deflation in the context of a liquidity trap, with the central bank’s policy rate pinned at zero, it is not enough for the central bank to print money, accommodating massive fiscal policy stimulus, he argued. Not that this is not a necessary policy action. It is. But it is not sufficient, Krugman pounded the table, because if the public believes that the central bank will, in the future, un-print the money – in today’s jargon, implement an exit strategy from money printing – then the printed money will simply be hoarded, rather than spent, because deflationary expectations will remain entrenched. To get the public to spend the money, Krugman argued, the central bank should make clear that the printed money will remain printed, shifting deflationary expectations to inflationary expectations. In his famous conclusion, actually advice to the Bank of Japan, Krugman declared (his italics, not mine):
“The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.”
I have a lot of problems with many of Krugman’s policies, but I think in this case, he has gotten it right. (I couldn’t resist putting in the next picture, which is not really relevant to this discussion, but does represent my main problem with Krugman’s policies, but more importantly just makes me laugh.)
The fact that the market understands that the ECB is constrained in its ability to be “irresponsible” is going to severely hamper the effectiveness of Draghi’s policies. Don’t forget that even the Fed had difficulties with their first two QE programs because they stated the size of the program in advance. It wasn’t until the third QE program, which was unlimited in size, that the Fed was able to influence markets in their intended manner.
Mario Draghi’s problem is made all the worse by the fact that he needs to achieve a consensus before instituting it. Therefore he has had to present his program to all the relevant parties, including even meeting directly with Merkel to get her blessing. The details of the program have undoubtedly been leaked, and although I am not in the know, I am sure the big hedge funds have most of the information already.
Over the past week, the German DAX stock index has powered to new highs while the Euro has sunk to new lows. The market has front run the program, and we very well might be in an “all baked in situation.”
We won’t know for sure until we see the final details, but if I were Draghi, I would have worked harder at keeping expectations contained so that I could under promise and over deliver.
I worry that any sort of disappointment is going to cause a major adverse market move. Given the hype going into the January 22nd ECB meeting, I sure hope that Draghi kept a few aces up his sleeve.
The market is mostly focused on the size of the ECB program, but there are a couple of other aspects that should not be overlooked.
Firstly, I still think there is a decent chance that the ECB pushes the short end of the curve even more negative. The taboo of negative interest rates has been broken, and the Swiss National Bank have thrown down the gauntlet with their move to minus 75 basis points. I expect at least a move of another 25 lower for the ECB at the next meeting, with an outside chance that they match the SNB with a move to minus 75. This might be the part that Draghi is holding back to make sure that the market is pleasantly surprised. Conventional (if you want to call negative rates conventional) monetary policy is where the ECB has the clearest power. It would make sense that this is probably the easiest part for Draghi to implement, and therefore he doesn’t need to signal this in advance.
The second thing that should be considered was brought to my attention by a great piece by Scotiabank’s Guy Haselmann. He argues that the manner in which the ECB executes the QE program is going to be important. If the ECB takes all the risk onto their balance sheet, then that will signal that the union is irreversible, and the politicians are treating it that way. But if they choose to allow each nation’s Central Bank to do the Quantitative Easing on their respective balance sheet, that will indicate that they are worried about the eventual disintegration of the union. Haselmann argues that the market will treat this type of QE much less favourably.
The chances for an accident on the 22nd are high. Draghi is in a really difficult position, with very few good options. He has lost the element of surprise and the market is expecting a lot from him. I don’t think he can be “responsibly irresponsible” enough to do more than temporarily arrest the deflationary vicious circle. For his sake, I hope I am wrong…