Markets were unimpressed by the ECB President’s plan to intervene in sovereign bond markets but the initiative adds to a series of steps* taken by Sig. Draghi since assuming leadership of the central bank, the cumulative effect of which has been to reverse the monetary tightening that occurred under his predecessor, thereby improving prospects for the Eurozone economy.
There are two glimmers of hope in recent data. First, the six-month rate of change of Eurozone real narrow money M1 (i.e. deflated by consumer prices, seasonally adjusted, not annualised) rose further to 1.1% in June, the highest since September 2010 – see first chart. A contraction of real M1 in late 2010 / early 2011 and again last winter signalled the current recession. The recent recovery – predating the July cut in the refinancing and deposit rates – suggests that Eurozone-wide output will stabilise in late 2012.
Secondly, ECB lending to banks (i.e. either in refinancing operations or through the “back door” of national "emergency liquidity assistance" operations) has fallen slightly since mid-year following a surge in June – second chart. This could indicate a slowdown in deposit outflows from peripheral banks into the core, in turn suggesting a stabilisation of central bank imbalances within the TARGET2 clearing system.
The country breakdown of the monetary statistics shows a large contraction of real M1 deposits in the periphery in the six months to June, in contrast to a rise in the core, implying worse economic prospects – third chart. The gap, however, has narrowed and peripheral real deposits have risen in three of the last four months – fourth chart.
The news, in other words, is improving at the margin and President Draghi’s latest initiative should sustain the trend. Markets may be underestimating the differences between the new plan and the ineffectual securities markets programme – intervention will be “of a size adequate to meet its objective” rather than “temporary and limited”, the ECB will not assert credit seniority and bond-buying may be allowed to expand the monetary base. The key risk is that the German government will torpedo the plan by backing the Bundesbank’s opposition – but Sig. Draghi is unlikely to have launched his initiative without securing the implicit support of Chancellor Merkel.
*These steps include three quarter-point cuts in the key refinancing rate, a reduction to zero in the deposit rate paid on “excess” bank reserves, the injection of €1.0 trillion of subsidised medium-term funding – equivalent to 11% of Eurozone annual GDP – in the three-year LTROs conducted in December and February, and a loosening of the ECB’s collateral regime.
