The ECB’s Diminishing Room for Manoeuvre

European Central Bank (ECB) President Mario Draghi did not disappoint. In his first post-summer press conference, he responded to the recent volatility on Chinese equities markets – and across emerging markets more generally – by promising to relax monetary policy as much as necessary to shore up Europe’s fragile recovery. He articulated the promise in the form of a three-fold commitment: to expand the share of individual bond issues that the ECB could purchase without giving the central bank unwarranted market power; to maintain the pace of monthly asset purchases; and to loosen monetary policy even further ‘by using all instruments available within its mandate’ particularly as this refers to ‘the horizon, the size, and the parameters’ of ‘the asset purchase programme’. Market participants were quick to respond. The euro weakened against the dollar; equity prices rose on European stock markets; and the yields on European sovereign debt instruments declined.

It is easy to interpret living up to expectations as a sign of the ECB’s continuing influence over the markets. ‘Never bet against Draghi,’ is a popular banter among analysts. The transcript of the press conference tells a different story. Time and again, Draghi explains how his quantitative easing program has underperformed due to the influence of exceptional factors. Periodic declines in commodity prices, prolonged weakness in emerging market economies, increasing volatility in asset prices, and adverse movements in exchange rates between major currencies all contribute to the explanation. Of course the ECB could try again and harder, but why should the next time be any different? This question is not simply a rhetorical flourish. The canned opening statement only makes sense if the first commitment to quantitative easing was a failure.

Draghi retains the ability to move markets but he is rapidly losing space to manoeuvre. This is clear from the structure of the opening statement. The technical decision to expand the share of any bond issue that the ECB can purchase is the first sign that the ECB will try to loosen monetary conditions. What this reveals is the frustration of those who designed the original program for monetary accommodation. Everyone knows that the ECB is a big player in the markets; that is why you would not want to bet against Draghi. Fewer people appreciate just how shallow are the pools of European assets that are available for purchase. Hence the challenge for the ECB is no different than for any other physician: do no harm. The ECB tried to meet this challenge with Keynesian assumptions. By adding to the demand for asset purchases, they should increase the supply available. So far that has not happened. Instead, the tendency for the ECB to create market distortions has at least kept pace with its ability to provide monetary stimulus.

The decision to expand the share of any bond issue that the ECB can purchase is not going to change that dynamic. Expanding the share of allowable purchases will increase the depth of the asset pool available, but that does little to close the gap between what the ECB could do given the theoretical size of its balance sheet and what the ECB can do given the supply of assets that is available. The qualification that the ECB will avoid acquiring a ‘blocking minority’ is more important than the change in maximum issue shares in that respect. The ECB is a market distortion by definition; the expansion of the issue share that the ECB is allowed to purchase only underscores that fact.

This leaves us with the commitment to extend the quantitative easing program if necessary at some future moment between the September 2015 press conference and the September 2016 notional end to the purchases. This future extension of quantitative easing only matters today in a world framed by rational expectations, where market participants bring the future into the present through their buying and selling of marketable assets. This is why the euro fell against the dollar and it is why European sovereign debt yields declined more generally; the rise in European equity prices is a second-order result of market expectations about the depreciation of the euro and the decline in European interest rates.

Yet if rational expectations is the mechanism that the ECB can trigger, it is worth considering why Draghi offered such a half-hearted commitment. At best he made it possible to loosen monetary conditions in the future; he did not promise that he would do so with his feet firmly planted in the present. The explanation is that coyness is the ECB’s most potent remaining instrument. If the ECB can move markets today by opening the door to future commitment, it can hold onto the possibility of using firm commitment to move markets again in the future. Unfortunately this is not an inexhaustible asset. Instead the distinction between the promises that Draghi can make today and those that he can only leave open against future need is a measure of ECB’s diminished room for manoeuvre.

NB:  This essay first appeared in edited form on MNI’s Euro Insight.