Draghi's parting gift to tie Lagarde's hands
By Balazs Koranyi
FRANKFURT (Reuters) - The European Central Bank's imminent stimulus package is unlikely to cut record low borrowing costs much further but will tie its new president's hands for much of the next year, giving her little leeway to act while the economy ails.
With the bloc's vast manufacturing sector shrinking, a global trade and currency war escalating and a hard Brexit looming large, the ECB has already signalled more support for the euro zone economy, hoping to arrest a dangerous downward spiral that could lead to a recession.
But it faces two big problems: the bloc's troubles are imported so largely outside the control of monetary policy, and the bank's remaining instruments are of limited efficacy given record low borrowing costs.
Indeed, the widely flagged umpteenth round of ECB monetary easing since 2011 may wipe out the little firepower the central bank has left and undermine the credibility of its claim that it would one day be able to turn the money tap off.
Germany can already borrow at minus 0.6% for ten years and interbank markets price 30 basis points of ECB deposit rate cuts to minus 0.7% in coming years, putting them in the ballpark of the reversal rate at which more cuts become counterproductive.
Still, ECB President Mario Draghi, who hands the helm to Christine Lagarde at the end of October, seems keen to avoid any talk that the bank's firepower is limited, suggesting that policymakers will combine several moderate steps into a package on Sept 12 to give markets the impression of a big move.
"The main goal of the package is to preserve the financial easing they already achieved," Frederik Ducrozet, a strategist at Pictet Wealth Management said. "It would be unacceptable for the ECB to admit that any new easing would be less effective because of diminishing returns."
The package is likely to include a deposit rate cut and fresh asset purchases, and possibly a multi-tier deposit rate, which would shield banks from some of the negative side effect of super low rates.
The cut's potency is marginal given how low the rate already is. And the ECB's balance sheet is already at 4.7 trillion euros, indicating that asset buys would have to be massive - and hence politically contentious - to have a tangible impact.
JPMorgan estimates that to lift inflation expectations, the ECB's easing package would have to equal about half of its combined measures since 2014, so 1.25 trillion euros of asset purchases and another 350 billion euros of ultra cheap loans to banks. And even that might not be enough to put inflation back on target.
A weaker euro would definitely help, but that is hard to achieve when the Federal Reserve is also easing and the U.S. administration is grumbling about a strong dollar.
Tiering would immediately help banks but it is the most difficult of the measures to reverse given its complexity and would thus tie the hands of Lagarde the longest.
NO BIG FIRST IMPRESSION
Draghi's farewell package will consume much of the bank's remaining firepower, making it difficult for Lagarde to make a big first impression - the very thing Draghi did eight years ago when he cut rates at his very first meeting, reversing an earlier misconceived hike.
"This is already almost as dovish as it gets," ING economist Carsten Brzeski said.
"If you see the September package as mostly a confidence booster, you also tie Lagarde’s hands because the economy won't change significantly between September and her first meeting in December."
The ECB also has no influence on the trade war between China and the U.S., and no impact on Brexit.
Lagarde's room for manoeuvre on interest rates will also be mostly tied by the ECB's forward guidance, which defines the rate path through mid-2020 and is also seen changing next month.
The ECB could take an even more accommodative stance. But every subsequent move comes at a cost, would take significant preparatory work and could even involve a broader review of where the bank is heading.
Buying bank bonds, for example, could make a quick impact, helping lenders who transmit the ECB's easy policy to the real economy.
But buying debt from institutions directly supervised by the ECB is politically and legally contentious, raising questions about conflict of interest.
It could also buy more private debt but the bank already got burnt buying corporate bonds, leaving little appetite for more risk. Stocks are also a possibility but may yield little and fuel accusations that the ECB is merely helping the rich.
(editing by John Stonestreet)