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Mario Draghi Holds Off Loosening Monetary Policy, Giving the Fed the Right of Way

The European Central Bank isn’t quite ready to join the global monetary policy easing party yet, but Mario Draghi wants you to know he’ll be right there, just as soon as his bean-counters are ready.

Many in financial markets had expected the eurozone’s central bank to act already this week, given a series of dire economic data, notably from the region’s traditional powerhouse, Germany. A sizeable minority had hoped for a cut of 0.1% percentage point in its key deposit rate, which would have taken it to a new record low of -0.5%.

Instead, the ECB left rates unchanged, relying on the prospect of a much broader stimulus package after the summer to settle market nerves. To little avail: financial markets leaped initially, but reversed course when the realization sank in that today was ultimately all words and no action.

Its inaction was largely a function of deference to the Federal Reserve, which has itself all but promised a cut in its own key interest rate next week. The Federal Open Market Committee will start a two-day meeting on Tuesday, 30th July.

While the consensus forecast there is for a 25 basis-point cut in the Fed funds target rate from the current range of 2.25% to 2.50%, there have been some indications that a half-point cut is also possible. John Williams, the New York Fed president who is one of the FOMC’s more influential members, said last week that prompt and decisive action could “vaccinate the economy and protect it from the more insidious disease of too-low inflation” or an economic disaster.

There’s no doubt that the Eurozone economy needs help: according to IHS Markit, manufacturing activity shrunk at its fastest rate in over six years in July. Even worse, there are signs that what has so far been mainly a manufacturing slowdown is now spreading to the much larger services sector. Ifo’s German business climate index indicated on Thursday that the service sector expectations are now bleaker than at any time since 2009.

“The recession risks for the German economy have clearly increased,” said Nordea Markets’ Jan von Gerich in a research note.

Draghi, meanwhile, has said a region-wide recession is still unlikely, but acknowledged that the risks were skewed to the downside. Accordingly, the bank reintroduced forward guidance that the next move in rates could be down, rather than up.

Draghi also indicated that some of his colleagues had agitated for immediate action. But sadly, the ECB’s number-crunchers haven’t yet worked out how to cut interest rates further without destabilizing the banking system, or how to tweak the rules of the ECB’s quantitative easing program to let it put more downward pressure on long-term rates. The relevant committees will be working on solutions for the next meeting in September. They can expect to have their aircon turned off if they don’t come up with the goods.

Draghi has generally succeeded in convincing markets that he can keep the show on the road for the last eight years. As such, Thursday’s reaction was probably a mild disappointment. But the disappointment would have been far greater if the ECB had cut by a timid 10 basis points this week, only to see its relative impotence exposed by aggressive Fed action next week.

Just as importantly, argued IHS Markit’s chief European economist Ken Wattret, the ECB needs to get others—notably Eurozone treasury chiefs—to help with the heavy lifting, which is a point that Draghi never tires of making.

“The decision not to launch today likely reflects tactical preferences, including the proximity of next week’s FOMC decision and constraints on the available ammunition,” Wattret said in emailed comments.

But, he added, “timing may be irrelevant to a much broader issue—expectations need to be managed about what looser monetary policy can achieve from this point.”