European Central Bank is caught between a rock and a hard place
ECB President Mario Draghi faces tough choices as Italy heads into a constitutional referendum and the US prepares to raise interest rates
Spare a thought for Mario Draghi, the Italian president of the European Central Bank (ECB).
Next Thursday, Draghi will hold one of his most eagerly awaited press conferences following the ECB’s monthly policy meeting. He will be speaking four days after a high-stakes referendum on constitutional reform in Italy which premier Matteo Renzi is expected to lose and six days before the US Federal Reserve’s widely anticipated decision to raise interest rates for the first time since last December.
Both of these developments are likely to have significant implications for global financial markets, already in a state of flux because of expectations that US President-elect Donald Trump will unveil a hefty fiscal stimulus programme that will fuel inflation, forcing the Fed to raise rates more aggressively next year.
The immediate concern for the ECB is the fallout from a “No” vote in the Italian referendum on Sunday.
The closely watched yield on Italy’s 10-year bonds has surged nearly 100 basis points since mid-August - with nearly half the increase occurring over the past month - to just under 2 per cent amid fears that renewed political instability in the euro zone’s third-largest economy could precipitate a full-blown banking crisis in a country burdened with a dangerously high share of non-performing loans (NPLs).
In its latest Financial Stability Review, published last week, the ECB cites global political risks, particularly in the US, as a threat to euro zone financial markets. Victor Constancio, the ECB’s vice-president, candidly admitted that it was “impossible to predict” how a “No” vote in Italy would impact Europe’s vulnerable single currency area.
The recent sell-off in global debt markets makes the ECB’s job doubly difficult.
The dramatic increase in benchmark US 10-year Treasury yields - up 55 basis points in November (the sharpest monthly rise since December 2009) in what has been the most conspicuous manifestation of the so-called “Trumpflation trade” - is putting upward pressure on Europe’s bond yields. German 10-year yields, which were in negative territory as recently as early October, now stand at 0.27 per cent.
Rising bond yields in the US, where growth and inflation are higher and are likely to accelerate further if Trump pushes through a major fiscal stimulus package, are one thing. A rapid increase in borrowing costs in the euro zone, where the ECB is still implementing an aggressive programme of quantitative easing (QE) involving purchases of bonds worth 80 billion euros a month to help ease bank lending to businesses and households, is quite another.
With the provisional end date for the ECB’s current QE programme only four months away, Draghi must explain to investors how Europe’s central bank intends to keep monetary conditions ultra-loose in the face of a sell-off in bond markets, mounting concerns about political risks in the euro zone (which will intensify in the event of a “No” vote in the Italian referendum) and, crucially, a backlash against the ECB’s negative interest rate policy.
The most likely option is an extension of the QE programme, possibly by reducing the amount of monthly purchases slightly in order to prolong the scheme for a sufficiently long period to meet the ECB’s 2 per cent inflation target.
On Wednesday, a report from Eurostat, the EU’s statistical agency, showed that headline inflation in Europe’s single currency area in November rose to 0.6 per cent, up from 0.5 per cent in October. However, core inflation, which excludes volatile energy and food prices, remains stuck at 0.8 per cent, even lower than at the beginning of this year.
The ECB can’t afford to begin scaling back, or “tapering”, its QE programme if it wants to appear credible in its determination to meet its inflation target.
Yet the technical and political constraints to implementing QE in the euro zone are becoming more apparent by the day.
While euro zone bond yields are rising - particularly in vulnerable southern Europe, the region most in need of low borrowing costs - Germany, the euro zone’s largest and most creditworthy member state, wants the ECB to start winding down its QE programme, which it sees as counterproductive and hugely detrimental to the interests of German banks and savers.
The nightmare scenario for Draghi is that his home country descends into a full-blown political and financial crisis in the event of a “No” vote in Sunday’s plebiscite, forcing the ECB to buy more Italian bonds to help restore confidence.
Yet even if Renzi wins his referendum, Draghi has plenty of other problems on his hands.
Nicholas Spiro is a partner with Lauressa Advisory