In the U.S.: Draghi May Copy Bernanke on Path to Low Rates

9 January 2012

Quantitative Easing (QE) Euro-style? U.S. Fed may serve as model for Europe as “economic pain” is “set to intensify.”

European Central Bank President Mario Draghi may act more like Ben S. Bernanke than Jean-Claude Trichet in 2012.

With the euro area’s debt crisis pulling its economy into a second recession in three years, Draghi soon may cut the ECB’s benchmark interest rate (EURR002W) below 1 percent for the first time and help banks by further inflating its balance sheet, which already has ballooned 17 percent since he took office Nov. 1.

Such activism would mark a reversal from a year ago — when the Trichet-led ECB was pivoting toward higher rates — and is causing economists at Bank of America Corp. and Jefferies International Ltd. to declare that Draghi is behaving more like Federal Reserve Chairman Bernanke than his ECB predecessor. If the slump drags down Germany, Europe’s largest economy, and fans deflation, it may even prompt the bank to consider Fed-style asset buying, providing relief it now balks at for governments.

“There is a sizable difference in just two months between Trichet and Draghi,” said Laurence Boone, chief European economist at Bank of America Merrill Lynch in Paris. “If you put Bernanke at one end of a scale and Trichet at the other, then Draghi would be moving toward Bernanke.”

Euro Decline

The likelihood of looser monetary policy leaves UBS AG forecasting the euro will record a third consecutive annual decline against the dollar. While the currency may enjoy occasional fillips on optimism that officials are stepping up their crisis-fighting, it will slide to $1.25 by the end of the year, predicts Beat Siegenthaler, a Zurich-based foreign- exchange strategist at UBS, the world’s third-largest currency trader.

The euro strengthened against the dollar for the first time in four days before German Chancellor Angela Merkel and French President Nicolas Sarkozy meet to flesh out a plan negotiated at a Dec. 9 summit for rescuing the euro area. It rose 0.5 percent to $1.2781 as of 10:31 a.m. in London.

“The single biggest reason to expect the euro to underperform in 2012 is that the ECB is highly likely to keep pumping liquidity into the system,” Siegenthaler said.

ECB Insights

Investors may glean their first insight into the ECB’s 2012 strategy on Jan. 12, when Draghi chairs a policy-setting meeting of its 23-member Governing Council for a third time. The Frankfurt-based central bank will leave its key refinancing rate at 1 percent, according to the median (EURR002W) of 51 forecasts in a Bloomberg News survey.

By the middle of the year, the council will reduce its benchmark to 0.5 percent, a record low, say BofA Merrill Lynch and Jefferies, as well as Citigroup Inc., JPMorgan Chase & Co. and Barclays Capital.

Juergen Michels, chief euro-area economist at Citigroup in London, is among the most pessimistic about the economy. He estimates it will contract 1.2 percent this year and 0.2 percent in 2013 after 1.5 percent expansion last year. That will push inflation to about 1.1 percent in the second quarter of 2013 from 2.8 percent (ECCPEST) last month. The ECB’s goal is just below 2 percent.

Such a backdrop will force the ECB to cut rates to 0.5 percent in the second quarter and swell its balance sheet by buying more government and so-called covered bonds, along with easing again the collateral criteria it imposes when lending to banks, he said.

Household Loans

Recession indicators for the region already are flashing red. Data last week showed unemployment holding at a 13-year high of 10.3 percent (UMRTEMU) and confidence (EUESEMU) in the economic outlook falling to the lowest in more than two years. Services and manufacturing output contracted for a fourth month in December.

The rate of expansion in M3 money supply (ECMAM3YY), which the ECB uses as a measure of future price pressures, fell to 2 percent in November from 2.6 percent in October, while the annual growth rate for loans to households and companies slowed a percentage point to 1.7 percent from the previous month.

Driving the slide is a debt crisis that began in Greece in late 2009 and has since infected Italy and Spain, the region’s third and fourth largest economies. The year begins with Italy (GBTPGR10) still paying 5 percentage points more than Germany (GDBR10) to borrow for 10 years and facing the need to redeem about 53 billion euros ($67 billion) of debt in the first quarter.

Fiscal Squeeze

The economic pain is set to intensify. A fiscal squeeze of almost 2 percentage points of gross domestic product this year will help push unemployment above 11 percent for the first time, JPMorgan Chase economists predict. Lending standards also may tighten as banks struggle to fund themselves.

“Either the ECB acts boldly enough to get the euro-zone confidence crisis under control, allowing global growth to regain momentum, or the crisis spirals out of control, pushing the world into a severe recession,” said Holger Schmieding, chief economist at Berenberg Bank in London.

Not everyone is as fearful. Erik Nielsen, chief global economist at UniCredit Group in London, forecasts the euro-area economy will expand 0.6 percent this year as its cheaper currency spurs trade, allowing the ECB to keep its refinancing rate at 1 percent. The central bank’s liquidity provisions at the end of last year also have helped restrain some borrowing costs for nations including Italy and Spain.

“We think we are close to the bottom” of the turmoil, Nielsen said.

Inflation Concerns

Greater stimulus would be a switch from a year ago, when inflation concerns were pushing Trichet’s ECB to shift toward rate increases. Policy makers raised their benchmark 25 basis points in April and again in July to 1.5 percent. They also debated ways to wean banks off aid before becoming addicted.

Easier monetary policy also would imply the ECB is more aggressive than when it last faced a recession in 2008. It raised its main rate even after the slump had begun, and officials later chafed at pushing it below 1 percent, because doing so might distort markets and lessen pressure on banks to recapitalize.

A recovering global economy then handed them a reason not to go as low as the Fed. The rate on overnight loans among banks in the U.S. has been near zero (FDTR) since late 2008, when the central bank also began a program of asset purchases known as quantitative easing.

Draghi — like Bernanke, a former student at the Massachusetts Institute of Technology — already has made his mark at the ECB, which is mandated to focus only on inflation; the Fed also must try to contain unemployment.

The same week Draghi, 64, became president, he oversaw an unexpected rate reduction and warned of a “mild recession,” with a second cut the next month. His central bank also loaned 523 European banks 489 billion euros for three years, an unprecedented amount and period, and weakened collateral rules, allowing its balance sheet to soar to a record 2.73 trillion euros at the end of last year.

‘More Preemptive’

“The ECB is being more preemptive and aggressive now,” said Greg Fuzesi, an economist at JPMorgan Chase in London, who predicts central bankers will cut their key rate to 0.5 percent, keep offering banks long-term cash beyond February and provide financial support for theInternational Monetary Fund.

Draghi’s grounding as an economist — compared with Trichet’s background as a French bureaucrat — is one reason for his greater pragmatism, said David Owen, chief European financial economist at Jefferies in London. Draghi was the first Italian to secure an economics doctorate from MIT in Cambridge, Massachusetts, and worked at Goldman Sachs Group Inc.

Ignoring Germany

Boone at BofA Merrill Lynch says Draghi appears less committed to the “separation principle” — the idea that the ECB should discriminate between measures to ease markets and steps to guide the economy. Changes on the ECB’s six-person Executive Board, which split under Trichet over bond-buying, also embolden him, she said.

Two new members joined this month from the finance ministries of France and Germany, and Draghi last week agreed to put Belgium’s Peter Praet in charge of economics, ignoring calls from Germany that one of its nationals keep the job.

The ECB still may be unwilling to pare its benchmark too close to zero, to maintain a corridor between it and the smaller deposit rate (ECBRON), which it pays on overnight loans parked with it, said James Nixon, co-chief European economist at Societe Generale SA. A much lower benchmark would make it unattractive for money-market funds and banks to lend, he said.

“As the whole thrust of providing liquidity is to get money markets to work, changing incentives is not helpful,” said Nixon, who anticipates the ECB will stop cutting the refinancing rate at 0.75 percent.

Unlimited Firepower

If the economy keeps deteriorating even after the rate cuts and more liquidity is needed, the ECB may end up following the Fed and Bank of England by buying assets in bulk and not offsetting the purchases, said Owen at Jefferies. Such an initiative may come as soon as March and initially involve promising to buy as much as 500 billion euros of bonds across the region over three months, he said.

The ECB has so far refused to use its unlimited firepower to defeat the fiscal crisis. Officials warn that doing so would amount to a bailout of governments and lessen pressure on them to restore fiscal order. While it has bought the bonds of some stressed countries, Draghi says the program is aimed at stabilizing markets and is temporary and limited.

The result has been ECB asset purchases totaling about 3 percent of GDP, compared with more than 15 percent by the Fed and Bank of England, according to Berenberg’s Schmieding.

Bundesbank Opposition

Bundesbank President Jens Weidmann, who opposed buying Italian and Spanish bonds, said Jan. 3 it would be “profoundly wrong” to step up the purchases to contain the fiscal crisis. The influence of Germany’s central bank at the ECB shouldn’t be underestimated and means it would back quantitative easing only if its price-stability mandate is jeopardized, said Stephen Jen, managing partner at SLJ Macro Partners LLP in London.

Draghi has echoed German officials in demanding governments introduce a “fiscal compact” to control budgets in the future.

“Mr. Draghi is closer in his thinking and ideology to the views held within the Bundesbank than people appreciate,” Jen said.

A deep recession in which inflation fell short of the ECB’s aim still may spur quantitative easing. Before he left the Executive Board last month, Lorenzo Bini Smaghi told the Financial Times he saw “no reason” why the bank couldn’t take such a step if “economic conditions justify it.”

Ed Yardeni, president and chief investment strategist at Yardeni Research Inc. in New York, says the ECB already has joined the “QE Club” indirectly with its lending to banks, which then can use the funds to buy government debt.

Save Banks

That view is rejected by Stephen King, chief economist at HSBC Holdings Plc in London, who says the ECB is, for the moment, trying to save banks and keep open the channel through which lower interest rates are transmitted rather than actively aid growth and governments.

ECB data also suggest banks are recycling the cash into overnight deposits at the central bank rather than lending it or purchasing bonds. Financial institutions left 455.3 billion euros with the ECB on Jan. 5, a record amount.

The irony is that if it ultimately buys more government debt to defend price stability from deflationary forces, the ECB could quell the debt crisis anyway by reducing bond yields, King said.

“Things have to get worse in the euro zone before they get better,” he said. “If you have a recession and concerns of too-low inflation, you have a conventional reason for unconventional policy.”


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