Central Banks Holding the Course

Both the Federal Reserve and the ECB outlined plans to step in and to provide additional accommodation if financial and economic conditions did not improve. However, the ECB left rates unchanged, and the Federal Reserve essentially postponed a decision about quantitative easing (QE3) and additional bond purchases for another month.

Last week, ECB President Mario Draghi reminded investors that the ECB remained able and willing to act to defend the euro against disintegration. Draghi reiterated that the euro was irreversible, and noted that “…the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.” Investors concluded that the ECB would soon act to bring down sovereign yield spreads, probably through renewed bond purchases, and Spanish and Italian bond spreads versus Bunds narrowed sharply.

On Thursday, the ECB had the opportunity to complement its assurances with actual policy measures. Unfortunately, Draghi appears to have either overpromised or investors completely misunderstood him. First, the ECB failed to cut either the deposit rate or the refinance rate, despite acknowledging that risks to both growth and inflation were to the downside. Second, while noting that sovereign risk premia were at “unacceptable” levels, Draghi again repeated the mantra that government progress on fiscal consolidation, structural reforms, and institution-building are the keys to restoring long-term confidence in public finances. Third, Draghi noted that open market operations, if undertaken at all, would be heavily concentrated at shorter maturities, which he clarified as being securities with maturities of 12 months or less. Subordination issues, we were informed, would be addressed at some later point.

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