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Draghi Summons His Inner J.-B. Say

On Thursday morning, European Central Bank (ECB) President, Mario Draghi, delivered a monetary stimulus package that probably exceeded the expectations of the most optimistic market observers (or pessimistic, depending on your view).


Here is the new and improved plan:

  1. The Quantitative Easing (QE) program has been increased from 60 billion Euros per month to 80 billion Euros per month. The program is supposed to end in March 2017. In total, the program has been increased by 240 billion Euros.

  2. The amount of any single issue the ECB can purchase has been increased from 33% to 50%.

  3. European Investment Grade (IG) corporate bonds have been added as eligible for purchase by the program (this includes non-bank bonds).

  4. The ECB Lending or Refinance Rate has been lowered to zero. This is the rate that the ECB charges for loans to member banks.

  5. The Deposit Rate, the rate the ECB charges member banks for holding excess cash at the ECB, has been lowered from negative 30 basis points to negative 40 basis points.

A new four-year lending facility has been created, whereby member banks can borrow at the Refinancing Rate of zero (see bullet 4) to lend to the “real economy.” Furthermore, if the member banks show that they are actively lending the borrowed funds to the “real economy,” their borrowing rate could fall as low as negative 40 basis points. This means the ECB would be paying banks to loan money.

So, despite the hue and cry from the European banking sector and many market observers (including myself) that Negative Interest Rate Policy (NIRP) combined with QE actually hurts the banking sector, the ECB ramped up the policy significantly. However, the ECB feels they have solved this problem by creating a relatively long-term, fixed rate (at zero or lower) lending facility. What this means is that they may essentially end up paying the banks the same rate they are charging them on their deposits if they are good little European citizens and lend the money out to the “real economy.”

Considering we have just come from one of the greatest global credit disasters in the history of mankind, this seems pretty darn perverse. The ECB could potentially pay banks to lend. This isn’t quite like throwing pallets of Euros out of helicopters, but it is close. It may actually be worse! With this latest policy initiative, I believe that President Draghi has summoned his inner Jean-Baptiste Say, the infamous early 19th century French economist who is credited with the saying, “Supply creates its own demand.”

To me, this is the extremely flawed theory upon which the ECB is basing their latest policy. Loan demand in Europe (as well as much of the developed world) is very weak as economic final demand has slowed to a crawl. The ECB has to understand that there’s a reason banks have large amounts of excess cash on deposit to begin with! And yet, they are basing their latest policy on the belief that if they just create the supply of funds, the demand will magically arrive to consume it. Additionally, the ECB is saying something like this to its member banks: “We will continue to punish you if you keep excess cash in your ECB account by charging you 40 basis points to keep it there. However, if you use all that “creative lending ingenuity,” like the kind that got us into this mess in the first place, we will pay you enough to do so and offset the damage being done to you by NIRP.”

Brilliant! I believe that all the ECB is doing here is showing the world that the effectiveness of monetoary policy—no matter how massive and bold (or stupid)—to positively affect economic growth has, like itnerest rates, gone to zero. I have very strong doubts that this latest policy is going to work, especially when one considers that the ECB is directing its member banks to aggresively lend out moeny while simultaneously instituting stricter, more stringent capital rules for these same banks.

The sum of all central banks’ fears is going to be realized relatively quickly as the ECB’s latest policy does little to spark real final demand and economic growth. They will literally be out of ammunition. I think this is why when Draghi was asked yesterday whether he would be cutting rates further, he said that he didn’t anticipate more rate cuts based on his current view. While the question was absurd given the package Draghi just delivered, the market reaction to the answer was even more absurd (the Euro rallied from 1.08 to 1.12, European sovereign bonds sold off along with stocks). I think what Draghi was essentially saying was: “My friend, if what I just presented today doesn’t work, then cutting the Deposit Rate another 10 or 20 basis points isn’t going to help either.”

Member SIPC & FINRA. Advisory services offered throughSWBC Investment Company, a Registered Investment Advisor.

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