Why Draghi Lowered Interest Rates in a Surprise Move

September 5 2014

Draghi is a smart guy. If you read the headlines, it appears as if Draghi announced a bold move this week. Little has changed, however, after the slight policy changes already made in June this year. In fact, Draghi’s policy announcement was anything but bold. It was merely a humble extension of what the ECB already announced during the last interest rate decision last June.

Why Draghi Lowered Interest Rates in a Surprise Move

Draghi is a smart guy.

If you read the headlines, it appears as if Draghi announced a bold move this week. Little has changed, however, after the slight policy changes already made in June this year.

In fact, Draghi’s policy announcement was anything but bold. It was merely a humble extension of what the ECB already announced during the last interest rate decision last June.

What Draghi Did and Why He’s Making a Mistake

This week Draghi lowered interest rates from 0.15% to 0.05%. But there is no practical difference between the two. Even Draghi admitted that even lower interest rates wouldn’t achieve anything just three months ago. He stated that interest rates “for all practical purposes” were already at their lower bounds.

Even despite his remarks in June, he decided this week to lower the interest rates.

The lowering of the interest rate from 0.15% to 0.05% will have no effect whatsoever on the economy. And Draghi knows it.

So Why Did Draghi Lower Interest Rates?

Draghi is fully aware of the political implications of his decisions and public remarks.

There has been a public outcry for months, begging Draghi “to do something”. But Draghi knows very well that structural reforms are needed in Europe and that he is currently pushing a string.

For instance, Draghi recently argued in a speech at Jackson Hole that “very serious discussions” about structural reforms are necessary. Without structural reforms, “looser monetary policy [is] of little use,” he told his audience.

Many politicians haven’t listened to Draghi’s speech, however. French Prime Minister Manuel Valls came out last week asking for “weakening” an “overvalued” euro.

Now, if Draghi wouldn’t frame his humble change in policy as a “bold move”, politicians in France and other countries would keep complaining. Public pressure would increase. At least the ECB can now argue that it is “doing something,” even though they’re not really doing something. In short, he just prevented any severe political repercussions from allegedly “doing nothing.”

You Can Lead a Horse to Water, but You Can't Make It Drink

Growth remains fragile in Europe.

European GDP growth came to a standstill earlier this year, and now even the ECB lowered its growth expectations to (practically) zero growth.

Unemployment remains sky-high. Households and companies are still heavily burdened by debt.

As a consequence, the private sector is not to keen to go much further into debt.

In effect, it’s not the credit supply that is the reason for bank lending remaining depressed, but credit demand.

The solvency of European households and corporations is frail and no supply of liquidity will make them any more creditworthy. According to the ECB, bank credit to businesses has been declining 2.7% during the past six months, indicating that businesses pay more debt off than is borrowed.

In other words, you can lead a horse to water, but you can’t make it drink.

What If the Horse Decides to Drink?

If the horse actually decides to drink, lending standards will reach all-time lows and collateral will be of lower quality. Bank credit will flow to risky ventures, increasing the risk of incurring heavy losses in the future and potentially wiping out bank equity.

We really do not want to revive the bubble economy we have had from 2002 to 2007, leading to many of the problems we are facing today.

We’re in the current mess — high unemployment, pathetic economic growth, record high public, household, and corporate debt — due to the credit intoxication of the past decade. The solution is to sober up, not to get intoxicated again.

We could hardly call it a solution to repeat the causes of the Depression we’re currently in.

Why You Shouldn’t Expect Too Much

Gold prices went up about 1.5% after the ECB’s announcement. European stock markets moved higher and bond yields came down to even more ludicrous levels: the German government is now getting money in return (i.e., it has a negative interest rate) for borrowing for four years; Spanish and Italian 10 year yields are lower than the yield on US Treasuries.

But Draghi’s policy decision will have little repercussions in the middle term for the European economy in general, euro zone inflation or bank lending. And the thing is, Draghi knows it.

At most, the latest ECB package will lead to more bubbles and even more preposterous interest rates on European governments bonds. The ECB is apparently willing to blow the bond bubble to even more nonsensical heights.

Gold will not profit directly, but indirectly. When the bond (and stock market) bubble explodes, huge gaps will appear in bank balances, pension funds, and government budgets.

We buy gold today in anticipation of these problems down the line, as Draghi and European leaders are persistently kicking the can down the road.

Newsletter

Sign up for our periodical newsletter to stay informed about the gold and silver markets and special offers.