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Will Mario Draghi have to save the Euro one more time?

Will Mario Draghi have to save the Euro one more time? Shaun Richards

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The weekend that has just passed saw the annual central bank symposium at Jackson Hole Wyoming USA. The fact that the previous US Federal Reserve Chairman Ben Bernanke made significant policy speeches there made it an event of note. However it was not the present Chair of the Federal Reserve Janet Yellen who made a speech of significance this year. It was Mario Draghi, the President of the European Central Bank (ECB), who moved a few economic goal posts.

What did Mario Draghi have to say?

The first point at issue was his subject matter which I have highlighted below:

"No one in society remains untouched by a situation of high unemployment. For the unemployed themselves, it is often a tragedy which has lasting effects on their lifetime income. For those in work, it raises job insecurity and undermines social cohesion. For governments, it weighs on public finances and harms election prospects."

This is particularly interesting because unemployment is not one of the policy objectives of the ECB which is a pure inflation (close to 2% per annum) targeter. So Mario Draghi is deliberately diverting us from any over-emphasis on inflation which only got a few sentences, in spite of the speech being rather long.

Nonetheless, we did get something which was not far off ground-breaking:

"Over the month of August financial markets have indicated that inflation expectations exhibited significant declines at all horizons. The 5year swap rate declined by 15 basis points to just below 2% - this is the metric that we usually use for defining medium-term inflation."

This is significant as, up until now, the ECB told us regularly that "inflationary expectations are well anchored". Indeed, they have told us this so often it has become like a mantra they chant, and I have often wondered if they hope that if they keep repeating it they may even believe it themselves!

The reason that inflationary expectations matter was also highlighted in the speech:

"Inflation has been on a downward path from around 2.5% in the summer of 2012 to 0.4% most recently."

Until now, the "inflationary expectations are well anchored" line has been deployed by the ECB as a reason for it now responding more to the sharp decline in annual consumer inflation in the euro area. Accordingly, we have seen the first hint that this bulwark for ECB policy aspirations is beginning to crumble.

What does this mean?

We received  a clue as to what is likely to be coming over the policy horizon from this:

"The only conclusion we can safely draw, in my view, is that we need action on both sides of the economy: aggregate demand policies have to be accompanied by national structural policies."

Whilst structural policies are likely to be the most effective over time, the catch is that they take considerable time: firstly, to be implemented; and secondly, to have an effect. Improving the "skill intensity of the workforce" via education as suggested will take years and maybe decades to work fully. Thus, we find ourselves looking at the alternatives for boosting aggregate demand. One of them is within Mario Draghi's control:

"On the demand side, monetary policy can and should play a central role, which currently means an accommodative monetary policy for an extended period of time [...] we stand ready to adjust our policy stance further."

The other is something about which the ECB stance has until now varied from turning up its nose to in places like Greece helping to enforce exactly the reverse:

"Thus, it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this, while taking into account our specific initial conditions and legal constraints [...] in parallel it may be useful to have a discussion on the overall fiscal stance of the euro area."

As you can see that is something of a teaser about a potential easing of fiscal policy in the Euro area. The teaser was I think as much directed at Euro area governments as it was at the audience in Jackson Hole. If we travel on that road of an easier fiscal policy minds will wander and wonder if Mario Draghi is hinting that the ECB would assist in any fiscal easing via asset purchases under what is known as quantitative easing or QE.

The market response

Whilst the Euro did dip below 1.32 versus the US Dollar when markets re-opened for business the real response was to be found in the government bond markets. Amongst the rallies to be found in the Euro area was this consequence. The two-year bond yield in Germany fell to -0.04% and yes I do mean that investors are in effect paying Germany to hold its bonds. This cost may be small but is significant as bonds are usually seen a providers, not recipients, of yield/interest. Exactly how does this illustrate confidence in the economic prospects for what is usually considered to be the most powerful of the Euro area countries?

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