The Week After: The Hidden Surprise of the ECB Press Conference

December 14 2015

Someone knocks on your front door. You answer the door, and a well-dressed gentleman stands before you. He introduces himself and tells you: “Between now and 4 or 5 years, I will visit you again. I’ll walk into your home  and take at least 10 percent of the cash you have at home.” He then wishes you a great day and walks away. Keep this scene in the back of your mind as you continue reading.

The Surprise

On December 3rd, the Governing Council of the ECB had its last meeting of the year. Under the presidency of the Italian Mario Draghi, they made 5 policy decisions. First, the bank will continue its quantitative easing policy for a longer period of time than initially decided on (It was intended to run until September 2016, but has been extended to March 2017). Furthermore: commercial banks will have continued access to unrestricted borrowing until at least the end of 2017, the receipts stemming from government bonds that the ECB already owns will be reinvested, the deposit facility rate will be adjusted downwards from -0.2 to -0.3 percent, and the ECB will now also buy bonds from regional and local authorities in the euro area.

However, I feel that yesterday’s most important statement has nothing to do with these five decisions. The most important thing I’ve heard yesterday wasn’t part of the decisions made that day, but came forward during the press conference.

A journalist asked the ECB whether they would accept an inflation higher than the current target (which is below, but close to, 2 percent) in order to build a buffer against low inflation. Draghi responded by stating that: “our inflation rate ought to go close to 2 percent, but below 2 percent over the medium term.” While that is nothing new, it was followed by: “And one should certainly take into account the fact that it was well below 2 percent for a long time.” While this sounds innocent, let’s take a moment to think about what Draghi is truly saying.

After all, the ECB President implies that the bank has to account for low inflation during the previous years. Or, with other words, he considers that the difference between the target of 2 percent, and the true inflation rate, is a kind of tac carryforward for inflation, to be used in the following years! Imagine adding the 'unused inflation' to the current target of 2 percent; that seems to be the policy in the foreseeable future! This means that for the coming while, the ECB will allow for a higher inflation than its target of 2 percent. By stating that the ECB will 'use' it’s spare ‘tax carryforward,’ Draghi simply aims to catch up the destruction of money he accidentally failed to deliver.

And now let’s think about that well-dressed gentleman mentioned earlier; let’s call him Braghi. Are you going to leave your money at home, at risk to be taken when Braghi visits? Or will you make sure there will be not a single penny left to find? There is, of course, a possibility he will never show up. But do you want to find out while all of your money is stored at home? Just to be clear: the 10 percent mentioned in the opening paragraph refers to the inflation that will be imposed on us during the remainder of this decade.

And then there is something else: as previously said, one of the ECB decisions of past week was to extend the QE policies until at least March 2017. That means it is very likely that it will continue until the end of that year, if not the beginning of 2018. The first ECB interest rate hike will, obviously, not take place until the QE has been scaled down. It wouldn’t make sense to raise policy rates while the goal of a QE is to put downward pressure on those same rates.

Nor will the ECB start an interest rate hike immediately after the QE has ended. The Fed has ended its QE long ago, but its first rate hike still has to take place. As a result, the ECB may very well end up not raising interest rates at all this decade. And that would make Draghi a unique central banker.

He became the ECB’s President in November 2011. According to the EU rules, his appointment is an 8-year tenure, meaning that he would have to leave the ECB in October 2019. Draghi could therefore potentially become the first central banker to have never raised interest rates during his tenure!

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