Over in the Eurozone, ECB President Mario Draghi has been the Fairy Godfather of the bull market, not only in stocks but even more impressively in bonds, especially in the region’s peripheral countries. This past Saturday, at an IMF conference, he sought to reassure investors in these markets that the ECB will do whatever it takes to avert deflation.
Of course, he first made that pledge in the context of defending the euro in a speech on July 26, 2012. Now he is worried that the euro is too strong: “The strengthening of the exchange rate would require further monetary policy accommodation. If you want policy to remain as accommodative as now, a further strengthening of the exchange rate would require further stimulus."
On a year-over-year basis, the euro is up by 8% against the dollar and by 9% against the yen. In recent weeks, it has reached levels against the dollar not seen since late 2011. The strong euro is contributing to deflationary pressures by depressing import prices, which boosts the CPI, and by raising export prices, which could slow the Eurozone’s export engine.
"I have always said that the exchange rate is not a policy target, but it is important for price stability and growth," Draghi said. "What has happened over the last few months is that it has become more and more important for price stability."
On Sunday, at the same IMF conference, ECB executive board member Benoît Cœuré, in prepared remarks, reiterated that the bank’s Governing Council “is unanimous in its commitment to use also unconventional instruments within its mandate,” including asset purchases if additional easing is required to avert deflation.
Some observers claim that this is easier said than done since the ECB's charter forbids it from financing governments. However, buying government bonds in the secondary market isn’t explicitly prohibited. Since assuming the ECB presidency in November 2011, Draghi introduced two major unconventional policies to ease funding pressure in the Eurozone's banking sector:
(1) More than €1 trillion was pumped into the bloc's financial system between December 2011 and February 2012 through the provision of cheap three-year loans to banks. The banks used the funds to buy government bonds. Some observers called it "backdoor Quantitative Easing."
(2) In September 2011, Draghi launched his Outright Monetary Transactions (OMT) program to buy bonds in the secondary market. This ship never left port because of opposition from the Bundesbank. In addition, Germany's constitutional court in a preliminary ruling in February claimed, "there are important reasons to assume [OMT] exceeds the [ECB's] mandate.” However, final judgment was deferred pending a ruling by the European Court of Justice.
In any event, Draghi’s pledge to do whatever it takes to defend the euro worked like magic to ease financial conditions in the Eurozone. It’s not obvious how actually implementing a QE program now will work much better to boost inflation given that government bond yields are already so low. It would have to channel more of the monetary stimulus to the private sector through purchases of asset-backed securities, which are in short supply currently.
A QE program would have to dramatically lower the foreign exchange value of the euro. Over in Japan, the essence of Abenomics over the past year was to use massive monetary easing to depreciate the yen and boost inflation. But the shock-and-awe may be wearing off already. Central bankers may soon have to consider the possibility that they aren’t as powerful as they believe themselves to be against the forces of deflation.
Of course, he first made that pledge in the context of defending the euro in a speech on July 26, 2012. Now he is worried that the euro is too strong: “The strengthening of the exchange rate would require further monetary policy accommodation. If you want policy to remain as accommodative as now, a further strengthening of the exchange rate would require further stimulus."
On a year-over-year basis, the euro is up by 8% against the dollar and by 9% against the yen. In recent weeks, it has reached levels against the dollar not seen since late 2011. The strong euro is contributing to deflationary pressures by depressing import prices, which boosts the CPI, and by raising export prices, which could slow the Eurozone’s export engine.
"I have always said that the exchange rate is not a policy target, but it is important for price stability and growth," Draghi said. "What has happened over the last few months is that it has become more and more important for price stability."
On Sunday, at the same IMF conference, ECB executive board member Benoît Cœuré, in prepared remarks, reiterated that the bank’s Governing Council “is unanimous in its commitment to use also unconventional instruments within its mandate,” including asset purchases if additional easing is required to avert deflation.
Some observers claim that this is easier said than done since the ECB's charter forbids it from financing governments. However, buying government bonds in the secondary market isn’t explicitly prohibited. Since assuming the ECB presidency in November 2011, Draghi introduced two major unconventional policies to ease funding pressure in the Eurozone's banking sector:
(1) More than €1 trillion was pumped into the bloc's financial system between December 2011 and February 2012 through the provision of cheap three-year loans to banks. The banks used the funds to buy government bonds. Some observers called it "backdoor Quantitative Easing."
(2) In September 2011, Draghi launched his Outright Monetary Transactions (OMT) program to buy bonds in the secondary market. This ship never left port because of opposition from the Bundesbank. In addition, Germany's constitutional court in a preliminary ruling in February claimed, "there are important reasons to assume [OMT] exceeds the [ECB's] mandate.” However, final judgment was deferred pending a ruling by the European Court of Justice.
In any event, Draghi’s pledge to do whatever it takes to defend the euro worked like magic to ease financial conditions in the Eurozone. It’s not obvious how actually implementing a QE program now will work much better to boost inflation given that government bond yields are already so low. It would have to channel more of the monetary stimulus to the private sector through purchases of asset-backed securities, which are in short supply currently.
A QE program would have to dramatically lower the foreign exchange value of the euro. Over in Japan, the essence of Abenomics over the past year was to use massive monetary easing to depreciate the yen and boost inflation. But the shock-and-awe may be wearing off already. Central bankers may soon have to consider the possibility that they aren’t as powerful as they believe themselves to be against the forces of deflation.
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