Wednesday, August 8, 2012

The Draghi Code

Mario Draghi is very clever. He is also a bit hard to understand. English is not his native language. Indeed, it’s possible that something was lost in translation when he delivered his most recent comments in English at an investment conference in London on July 26 and at his press conference following the latest meeting of the ECB’s Governing Council on August 2 in Frankfurt.

Both were extremely important, in my opinion. Both sparked lots of controversy about what was actually said and intended. The remarks in London were off the cuff and suggested that Mr. Draghi was shooting from the hip. On the other hand, he started the press conference with a short prepared statement, and then responded to lots of questions from reporters with extemporaneous, but well-thought-out answers. Indeed, most of Draghi’s policy punch lines were delivered during the Q&A portion of the press conference.

Policymakers almost always announce their policy changes by reading from carefully prepared texts. Mr. Draghi seems to prefer an unscripted delivery of his message, which can be a bit disorienting for those of us conditioned to the more typical approach.

If my interpretation of his comments is correct, then Mr. Draghi may very well have eliminated the risk of a Lehman-style meltdown in Europe. This is a very big deal, indeed, and certainly more important than the LTRO that seemed big when it was introduced late last year, but lost its impact much faster than was widely expected. I reviewed Mr. Draghi’s press conference in Monday’s Morning Briefing. Allow me another chance to decipher what he said since it is as tough to do so as to crack the Da Vinci Code:

(1) What is the ECB’s mandate? Let’s first start with the most important statement he made in London: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” His other comments in London and Frankfurt strongly suggested that, in his view, the ECB’s mandate is in fact to do whatever it takes to preserve the euro!

Our friends at The Bank Credit Analyst recently observed that the ECB's actual mandate is spelled out in Article 105(1) of the Maastricht Treaty. It starts out stating that the ECB’s primary objective “shall be to maintain price stability.” It then states that the ECB will also support the euro zone’s “common market and an economic and monetary union.” The BCA team notes that a “breakup of the euro would cause wild swings in prices…hardly price stability in action.” Good point.

Draghi concluded his London presentation by claiming that the ECB’s mandate includes reducing “risk premia” charged on sovereign states' borrowing if they’ve widened because markets are betting that the sovereign states will be forced to default and leave the euro zone. He declared that the euro is “irreversible” and that the ECB will take whatever actions are necessary to “make it irreversible.”

(2) What’s the problem that needs to be fixed? In his prepared opening statement for the press conference, Mr. Draghi echoed the comments he made in London: “Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.”

(3) What needs to be done? In his prepared text, Mr. Draghi put the onus on governments to make the risk premia disappear by proceeding with fiscal consolidation and structural reforms. He acknowledged that this takes some time. In the interim, governments must allow the EFSF/ESM rescue funds to intervene in the bond market if circumstances warrant such intervention, but only if such help is provided to governments that are abiding by the funds’ strict guidelines.

If governments fulfill these requirements, then the ECB “may undertake outright open market operations of a size adequate to reach its objective.” The Governing Council might also implement “non-standard monetary policy measures,” which were not specified.

(4) What will the ECB purchase? In the Q&A session, Draghi provided a more specific insight into the ECB’s game plan for lowering risk premia. Open market purchases “will be focused on the shorter part of the yield curve” and in the secondary market. He noted that it is a very different approach from the previous Securities Market Program (SMP) in which the ECB purchased government bonds. He added: “As to the…question on why we are focusing on the short end of the yield curve, the main reason is that this falls squarely within the range of classical monetary policy instruments. The shorter the spectrum, the closer it is to money market operations.”

He refused to say whether the purchases would be limited or unlimited. The following response suggests that they will be open-ended: “[R]egarding whether it’s unlimited or limited--we don’t know! Basically, the Introductory Statement--and I am really grateful to the Governing Council for this--endorses the remarks that I made in London about the size of these measures, which need to be adequate to reach their objectives.”

(5) When will the ECB act? Draghi said, “The when is when governments have actually fulfilled the necessary conditions, namely have undertaken fiscal and structural reforms and applied to the EFSF with the right conditionality. At that point, we may act, if needed, along the lines that I have illustrated today.”

He stressed this point as follows: “But the Governing Council knows that monetary policy would not be enough to achieve these objectives unless there is also action by the governments. If there are substantial and continuing disequilibria and imbalances in current accounts, in fiscal deficits, in prices and in competitiveness, monetary policy cannot fill this vacuum of lack of action. That is why conditionality is essential. But the counterparty in this conditionality is going to be the EFSF. Action by the governments at the euro area level is just as essential for repairing monetary policy transmission channels as is appropriate action on our side. That is the reason for having this conditionality.”

This “conditionality” requirement is the main reason why the skeptics are skeptical that anything meaningful has changed in the ECB’s approach to easing the European financial crisis. In effect, Draghi is saying that if governments seeking aid from the rescue funds tighten their fiscal policies, the ECB will ease monetary conditions for them.

The skeptics may be right. Nevertheless, I think that Draghi made a very strong and unambiguous commitment to intervene as necessary to avoid a Lehman-style calamity. Near the end of his press conference, Draghi concluded, “[I]rreversibility means that it cannot be reversed. There is no going back to the Lira or the Drachma or to any other currency. It is pointless to bet against the euro. It is pointless to go short on the euro. That was the message. It is pointless because the euro will stay and it is irreversible.”

Today's Morning Briefing: 200 Days. (1) It still looks like a broad-based bull market in stocks. (2) Lots of record high 200-day moving averages. (3) Lots of confirmation. (4) Still a sector-neutral market with lots of outperforming industries. (5) They should continue to outperform. (6) More beats than misses in earnings. Not so for revenues. (7) Revenues more volatile than GDP. (8) Not-so-sweet spot for earnings. (9) Another batch of downers for global economy, especially in Europe. (More for subscribers.)

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