Having mislaid his bazooka in December, Mario Draghi has returned to the fray firing a blunderbuss. The ECB announced an unexpectedly wide range of easing measures, including cuts in all three key interest rates, an expansion and broadening of asset purchases, and a new TLTRO lending programme under which banks will be paid to borrow. While superficially impressive, this scattershot approach will probably have limited impact on monetary conditions and the economic outlook.

The main positive surprises in today’s announcements were: 1) a 5 basis point (bp) cut in the main refinancing and marginal lending rates, in addition to a 10 bp reduction in the deposit rate; 2) a €20 billion expansion of the monthly rate of asset purchases, with the programme extended to non-financial corporate bonds; and 3) new four-year TLTRO operations under which banks can borrow at the negative deposit rate if they expand their lending by modest amount over the next two years*.

These initiatives, however, are marginal. Market rates are now tied to the deposit rate, not the main refinancing rate. The cut in the latter will lower interest payments for banks currently borrowing from the ECB but will simultaneously reduce interest received on current account balances (i.e. required reserves) – the net impact on banks in aggregate will be insignificant.

Buying €80 billion rather than €60 billion of securities per month, meanwhile, is unlikely to exert much additional downward pressure on yields, although the extension to corporate bonds should depress spreads.

The new TLTROs will be welcomed by liquidity-short banks but institutions with excess reserves have little incentive to borrow, and the net impact on banking system income will be, at best, neutral – funds lent by the ECB will be reflected in a larger outstanding balance in the deposit facility, on which banks will be charged 40 bp, offsetting the TLTRO subsidy.

Relative to market expectations, the main negative surprises today were that the deposit rate cut was limited to 10 bp while the ECB has ruled out introducing a tiered payment system, which has been widely regarded as necessary for Eurozone rates to fall further towards Swiss / Danish levels. Indeed, Mr Draghi stated that he does not anticipate a further reduction.

The net impact of the package on monetary conditions and the economic outlook is likely to be small. The market reaction appears logical, with the euro stronger on reduced prospects of a further deposit rate cut, “core” government bond yields little changed and bank shares rallying as the deposit rate and TLTRO news has calmed fears of a squeeze on net interest margins.

*The requirement is to expand the stock of eligible loans by 2.5% between 1 February 2016 and 31 January 2018, or by less if such loans were reduced in the year to 31 January 2016.

Posts here in late 2014 and early 2015 argued for optimism about Eurozone economic prospects because monetary trends had strengthened significantly. Growth was solid in 2015 and domestically-generated inflation recovered. Monetary trends continue to give a reassuring message. Further monetary policy stimulus, therefore, does not appear to be warranted and – depending on the form it takes – may prove counterproductive.

Revised data released yesterday show that Eurozone GDP rose by 1.6% in the year to the fourth quarter of 2015 – see first chart. This is well above EU Commission, OECD and IMF estimates of potential growth in 2015 – 1.0%, 1.2% and 1.0% respectively. Potential growth was more than 2% when EMU began in 1999. In terms of the impact on the “output gap”, therefore, GDP growth of 1.6% now is equivalent to about 2.75% then.

The economy, moreover, was held back last year by a significant decline in net exports, reflecting global demand weakness. Eurozone domestic demand expanded by 2.2% in the year to the fourth quarter, the fastest annual growth rate since the third quarter of 2007 – first chart.

The labour market, meanwhile, has recovered solidly. The unemployment rate fell by a full percentage point between January 2015 and January 2016. The most recent employment statistics showed a 1.6 million* rise in the year to the third quarter of 2015, the largest annual increase since the second quarter of 2008.

Monetary policy doves claim that deflation risk has increased. The annual change in consumer prices fell below zero again in February, mainly reflecting further oil price weakness around the turn of the year, which has since reversed. Core inflation, however, has remained comfortably positive and above its 2014-15 low. The most comprehensive gauge of domestically-generated price pressure is the GDP deflator, which measures labour costs and profits per unit of output of all domestically-produced goods and services. The annual change in the deflator bottomed at 0.7% in the second quarter of 2014 and recovered to 1.3% in the second quarter of 2015, remaining at this level in the third and fourth quarters – second chart.


Monetary trends, meanwhile, remain solid. The monetary measure with the strongest correlation with future economic activity, according to ECB research, is non-financial M1, which rose by 9.8% in the year to January. Broad money M3 increased by 5.0% over the same period, above the ECB’s 4.5% “reference value” deemed to be consistent with its inflation target.

Based on the above, the case for further monetary policy stimulus is unproven. The ECB may argue that action is required as insurance against downside risks. The danger is that, far from providing stimulus, the measures under consideration will cause banks to slow balance sheet expansion while damaging consumer and business confidence.

*Figure corrected from earlier version of post.

ECB President Mario Draghi’s press conference statements always end by stressing the importance of “full and consistent implementation of the Stability and Growth Pact”. The words ring hollow because the ECB’s monetary largesse has encouraged governments to abandon fiscal consolidation.

The first chart shows the EU Commission’s estimates of the Eurozone structural or cyclically-adjusted budget balance, expressed as a percentage of GDP*. The structural deficit was cut by an average of 0.8 percentage points (pp) of GDP a year between 2010 and 2014. It widened, however, by 0.1 pp in 2015 and is projected to increase by a further 0.2 pp in 2016.

The rise in the deficit is at odds with revised guidelines on the implementation of the Stability and Growth Pact (SGP) published in January 2015. These guidelines link the required annual fiscal adjustment in a country to the level of GDP growth and size of the “output gap” (i.e. the deviation of GDP from potential). The Eurozone output gap was -1.8% in 2015 while GDP grew by more than potential, according to the EU Commission. Under these conditions, governments are required to strengthen the structural balance by 0.25-0.5 pp of GDP**.

The EU Commission expects GDP growth to exceed potential again in 2016, with the output gap narrowing to 1.1%. The recommended annual improvement in the structural balance under these conditions is at least 0.5 pp of GDP.

The rise in the structural deficit in 2015-16 would be larger but for a fall in debt interest costs caused mainly by the ECB’s policy actions. Eurozone debt interest is projected by the EU Commission to fall by 0.4 pp of GDP between 2014 and 2016 – second chart. Excluding interest, therefore, the structural balance is expected to deteriorate by 0.6 pp in 2015 and 2016 combined.

So governments have spent the interest windfall gifted to them by the ECB and engaged in additional fiscal loosening, despite Eurozone gross debt standing at 93.5% of GDP at end-2015 – far above the 60% maximum stipulated by the SGP.

The change in trend of the structural balance in 2015 coincided with the ECB launching QE. The ECB’s bond-buying removed any remaining market discipline on national fiscal policies. Financing costs for high-debt countries have plunged and governments have moved swiftly to reverse earlier consolidation. Excluding interest, structural deficits in Italy, Spain and Portugal are projected by the EU Commission to widen by 1.1, 1.3 and 1.8 pp of GDP respectively between 2014 and 2016.

The hypothetical Martian visitor would surely conclude that the ECB has engaged in monetary financing of peripheral governments, notwithstanding Mr Draghi’s casuistic protestations to the contrary.

The Draghi monetary striptease will become yet more daring this week. His actions are unlikely to stimulate the economy but will provide further titillation for debt-addicted Eurozone governments.

*The structural balance also adjusts for one-off and temporary measures.
**The recommendation is 0.25 or 0.5 pp depending on whether gross debt is below or above 60% of GDP.