D-Day for Draghi

Seventy years after the invasion of Normandy, Mario Draghi, the president of the European Central Bank (ECB), has a chance to liberate Europe anew. Tight credit markets have constricted growth in the eurozone and stoked fears of deflation. Draghi himself said "risks surrounding the economic outlook for the euro area continue to be on the downside" at his press conference last month. If he finally takes action on Thursday, the deliverance of an entire continent — or at least most of it — will be felt around the world once again. 

Last month, Draghi said the ECB was unhappy with the low level of inflation across the eurozone, which included deflation in Cyprus, Greece, Portugal, Spain, and Slovakia. The ECB is supposed to target an inflation rate just under 2 percent across the region to protect against the dual extremes of hyperinflation and deflationary doldrums, but prices rose by just 0.5 percent in the 12 months through March. Virtually all the modest inflation in the eurozone came from France, Germany, and Italy. They are the currency union’s three biggest economies, but, at least in theory, the ECB is not supposed to make policy just for them.

Draghi practically promised to act this month if new data continued to disappoint, and indeed they have. Even in Germany, increases in prices have slowed. And as I’ve written before, Germany seems to have an outsized say in what the ECB does. 

For those keeping score, this is the second big moment of Draghi’s tenure. The first occurred two summers ago, when he declared he would do whatever it took to protect the euro from crumbling and the eurozone from financial disaster. It was an important signal to the markets that the ECB would extend credit to struggling banks and even ensure the liquidity of governments in the eurozone. But it also showed that Draghi picked his moments carefully and acted in a dramatic and unequivocal way. This was exactly what a central banker was supposed to do; decisiveness and credibility were and are the sources of his power.

So what could his big move be this time? One possibility is an unprecedented shift to negative interest rates; the ECB would charge banks for holding reserves above the amount they are required by law to deposit. Commercial banks sometimes deposit extra reserves with central banks, even if those reserves earn no interest, in order to maintain a cushion of cash in case of large withdrawals — the kind of thing that might happen in a new financial crisis. But the ECB wants banks in the eurozone to lend as much as they can. Making them pay to hold excess reserves might force some of that money back into the credit markets. 

Another possibility is the adoption of a credit easing program like the one launched by Ben Bernanke, the former chair of the U.S. Federal Reserve. By buying different kinds of securities in private credit markets, the Fed was able to influence long-term interest rates in addition to the short-term rates it controlled via its usual tools in the federal funds market. So far, the ECB has been unwilling to dip into these private securities, but that could change this week.

Either of these moves would have profound effects on global credit markets. No central bank with a reserve requirement has ever set a negative interest rate on any commercial bank reserves. If this occurred without major disruptions, then the markets would look to other central banks in future downturns to make similar moves. The "zero lower bound" for interest rates would disappear, and expectations for the size of responses to new crises would grow. It’s a bit like estimating the average size of fish in a lake. If all the fish you see weigh between 1 and 3 pounds, but one day you catch one that weighs 8 pounds, then you have to assign a positive probability to a fish of that size appearing again. Central bankers would have a new weapon in their arsenal; under similar circumstances, investors would expect them to use it.

Credit easing is not unprecedented, but its effects would be no less dramatic for global markets. If the ECB initiates a program to buy tens of billions worth of securities in medium- and long-term credit markets, then it will likely continue for six months or more. As an economist, Draghi knows that big moves in monetary policy can take at least that long to percolate through the economy. Once he starts to see the effects, he will probably want to wind the program down gradually, as the Federal Reserve is doing with its own multi-year credit easing in the United States. But before he finishes, the eurozone may pass through a prolonged period of historically cheap money, which could lead to a huge buying spree for global investors. 

Indeed, since the late 1990s, these long spells of easy credit have come along as regularly as soccer’s World Cup — thanks to the world’s major central banks. First Japan brought interest rates close to zero, then the United States. The yen carry trade — by which investors borrowed in Japan for next to nothing and then bought higher-yielding securities, especially in emerging markets — became the dollar carry trade, and now it could well become the euro carry trade. The money sucked out of these markets when the Fed started talking about a taper could suddenly start to return.

Of course, it doesn’t help the eurozone much if all the new borrowing created by its policies is funneled into investments abroad. The mobility of capital makes the ECB’s task even more challenging, if its goal is to affect economic activity at home. That’s why the markets have been waiting for Draghi to do something big. And this time, unlike the D-Day invasion, everyone knows the date.