Friday, August 3, 2012

3/8/2012: Did Draghi quietly score a policy coup d'etat?

Let me revisit yesterday's assessment of Mario Draghi's statements. With time passing, it is becoming clear that the key (only) tangible positive is Draghi's comment that he will focus on the shorter end of maturity curve and that this will be consistent with two things:

  1. No commitment to sterilization, and
  2. Commitment to targeting 'traditional monetary policy' objectives.
Let me explain why I now think these are significant game changers for ECB, and potentially, for euro area.

For some years, even before the financial crisis hit, the ECB (including Trichet before Draghi) have been focusing or attempting to focus policymakers' attention on the need for structural reforms. In the past this was accompanied with threats of tightening monetary policy. But now, such threats are clearly not credible. Hence, the ECB, to stay on the message that long-term structural reforms must be pursued needed to achieve the following objectives simultaneously:
  • Reduce immediate pressure on funding indebted and deficit-laden peripherals (so reduce short-term borrowing rates)
  • Increase long-term pressure on the peripherals to incentivise them pursue longer term reforms (so increase slope of the yield curve)
  • Potentially support enhanced transmission of lower short-term rates into real economy (so alleviate pressure from sterilization of SMP), and lastly
  • Reduce future problem of unwinding SMP-accumulated 'assets' off the ECB balancesheet
Now, what Draghi set out yesterday as a potential plan does appear to do all of the four things above. By focusing SMP on shorter term end of the yield curve, ECB will indeed lower shorter-term borrowing costs for Italy and Spain (3-5 year max maturity), while steepening 10 year instruments costs to discourage, relatively, longer term borrowings. This means Italy and Spain should get an added incentive - growing over time as overall maturity profile of their debt starts to shorten as well - to enact long-term reforms. At the same time, ECB will be buying (assuming it does go through with the threat) shorter-term instruments, implying that unwinding these assets will be a natural process of maturity. ECB will not commit to sacrificing long-term flexibility of its policy tools by expanding SMP on the longer end of the yield curve, thus reducing overall risks to the monetary policy in the future.

Some thoughts for the weekend, folks...


Anonymous said...

So, what you're saying is because these profligate countries are placing their debt load on the front end (where they can get almost immediate monetization, as the front end is where the ECB will target) that this will solve problems? Looks to me like the debt they will be forced to issue at the ST end of the curve will be too much for any demand out there, lest the ECB get absolutely pushed to its brink (Germany will be thrilled). So Italy and Spain get an "incentive" to enact LT reforms and grow, but how is growth ever sprung strongly from increasingly austere conditions? Ask Krugman, ask Austrians, ask anyone...

And, maybe I am under the wrong impression, but isn't a publicly traded company who finances LT operations with ST money in constant fear of rollover risk? Now, yes ECB helps here for these stagnating countries, but the need for aid has been and is still underestimated. I say don't fall victim to the thought of success here.

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