The Euro
About the author:
- Author name:
- By Michael Knox
- Job title:
- Chief Economist and Director of Strategy
- Date posted:
- 07 April 2014, 8:16 AM
Mario Draghi, President of the European Central Bank, presented what was formally termed a 'lecture' in Paris on the 25th March 2014. The lecture detailed the history of the international financial crisis as it affected Europe and then the European financial crisis caused by the threatened breakdown of the Euro. He also described the reforms necessary to complete the Euro Area financial integration.
Draghi quoted Winston Churchill who said "to achieve great things, two things are needed; a plan and not quite enough time." He added that "I hope I have made clear today that we do have a plan. And since we certainly have no time to spare, I trust that if we remain resolute, great things for the Euro Area and its citizens can be possible."
In this post I'll focus on one area of this speech - the conduct of monetary policy.
Draghi notes "we have not only cut interest rates to our lowest level since the creation of the Euro, we have also introduced forward guidance, whereby we commit to keep our interest rates as low as they are currently, or even lower, for an extended period of time. This supports the economy today by steering expectations about the future. In particular, our forward guidance implies that short real rates, which are negative today, will become more negative in the foreseeable future."
Draghi points out that real rates will remain low because policy rates will remain lower in nominal terms while inflation will gradually rise. He further notes that expectations of lower short term real rates are also reflected in the low level of medium term rates. This is important because it is these medium term rates which are most relevant for the investment decisions of entrepreneurs. He notes that in this way the guidance on the level of rates tomorrow and the day after tomorrow supports investment today.
Draghi went on to say that he expected monetary policy to regain influence over the economic cycle and the accommodative stance would support a gradual closing of the output gap in coming years. This closing output gap and the falling unemployment level that it suggests is reflected in the ECB forecasts for rising inflation. Draghi noted that the ECB staff projections see inflation rising to 1% in 2014, 1.3% in 2015 and 1.5% in 2016. He notes "if any downside risks to this scenario appear, we stand ready to take additional monetary measure to ensure our mandate is fulfilled. In other words, we will do what is needed to maintain price stability."
Draghi goes on to remark that the accommodative monetary policy of the Central Bank has the extra advantage that it helps the ongoing process of deleveraging bank debt. He notes that it both reduces the numerator of debt ratios, that is the nominal interest rate and raises the denominator, that is the nominal growth rate.
What is Draghi telling us?
Draghi is telling us that real Euro Area interest rates will be lower for as far as the eye can see. Real interest rates under this scenario will be declining for the next two and a half years. This is in a world in which the Fed Reserve is already telling us that US interest rates are going to be rising after the second half of 2015.
Draghi is implicitly telling us we are living in a world in which the Euro is going to be weaker.
What we think
This year, as the US economy speeds up, relative to a slowly growing European economy, we think that the relative strength of the US dollar and the relative weakness of the Euro might become obvious more quickly than most commentators expect.
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