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ECB's new chapter won't see sharp rate rises anytime soon

As Mario Draghi bows out, central banks face fresh challenges, writes David Chance


Word is his bond: Outgoing ECB president Mario Draghi’s pledge to ‘do whatever it takes’ is credited with helping to save the euro from collapse in 2012

Word is his bond: Outgoing ECB president Mario Draghi’s pledge to ‘do whatever it takes’ is credited with helping to save the euro from collapse in 2012

Word is his bond: Outgoing ECB president Mario Draghi’s pledge to ‘do whatever it takes’ is credited with helping to save the euro from collapse in 2012

Next month the European Central Bank will end its €2.6trn bond-buying programme that has kept interest rates and bond yields in the eurozone at record low levels and helped heal the wounds inflicted by the 2008 financial crisis.

The move comes as the world's central banks unwind their support measures that had seen them accumulate a combined $14trn (€16trn) in bonds on their balance sheets as of end-September with the result that global interest rates are at their lowest levels in 150 years.

Surely from that kind of low, there is only one way for interest rates: upwards.

That means higher costs for mortgages and car loans and pain for indebted individuals and companies from the low-rate world. By the same token, savers who have suffered over the past 10 years will have some reason to cheer.

Not so fast. There will be market shocks along the way, but interest rates will likely remain low for years to come and barring a seismic shift in the global economy, possibly decades, in part thanks to today's combination of low policy rates and bond buying. Just to put the numbers in some context, the ECB bond-buying programme alone is equivalent to almost eight years of output from the entire Irish economy, based on 2017 data.

Europe's move comes to end new purchases of bonds as the Federal Reserve pushes ahead with disposing of part of its $4.5trn portfolio and raising interest rates and as the Bank of Japan, which embarked on bond purchases known as quantitative easing (QE) as early as 2001, scales back its purchases of bonds.


Investors are worried that it will "reinforce upward pressure on global yields" according to Shweta Singh, senior global economist at economic consultancy TS Lombard.

Things have not gone altogether to plan for the Federal Reserve in the US.

In 2017, it predicted that the end of QE would be as exciting as "watching paint dry" and while that was true for a while, recent rises in US real short-term rates have caused tighter financing conditions and raised questions about how much balance sheet unwind markets can absorb.

That means the Fed now has to intervene to prevent market rates rising too fast in its target range by paying higher levels of interest on reserves banks hold with it. It has also drawn criticism from Donald Trump who now accuses it of raising rates too fast and putting the economy at risk.

Mr Draghi has said he will not be hitting the brakes on the recovery in Europe by raising rates sharply any time soon.

He told the Oireachtas Finance Committee just last week that even after ending net bond buying the ECB "expected to keep interest rates at their present levels at least through the summer of 2019".

Mr Draghi, of course, knows that his words have power to move financial markets. He is after all the man who 'saved the euro'.

In 2012, the euro looked as through it was on the verge of collapse as bond yields of the so-called PIGS, Portugal, Italy, Greece and Spain surged as EU institutions looked paralysed.

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At a speech in London on July 26, Mr Draghi delivered his famous pledge that the "ECB is ready to do whatever it takes to preserve the euro".

His words were enough and the ECB did not have to deliver actual bond purchases until early 2015.

It also illustrates the degree of ambiguity that central bankers like to have and the power of words they use and with the vast resources at their disposal, the ability to quell market moves.

Even as he announced an end to buying new bonds, the Italian said that there was "a desire to maintain optionality in each and every part of this decision", which is central bank speak for "we can change course at any time".

Mr Draghi's dilemma, however, may not come from raising rates at all. He may leave office when his eight-year term ends in October next year without having done so once.

His successor will be confronted with a world that has changed beyond recognition since the ECB was founded in June 1998 with the mandate of ensuring economic stability.

According to research published this week by economists at the New York Federal Reserve Bank and the Federal Reserve Bank of Dallas on the VoxEU portal (https://voxeu.org/article/global -trends-interest-rates), real interest rates across the globe have fallen by about two percentage points over the past 30 to 40 years.

That has been driven, they argue, by lower overall economic growth rates, demand for liquid and safe assets like government bonds, which in turn has been fed by ageing populations - if you are older you tend to invest in safer, lower-yielding assets - and by the experience of economic crises, such as the Asian financial crisis in 1997 and the Russian debt default the following year.

According to the research from economists Marco Del Negro, Domenico Giannone, Marc Giannoni and Andrea Tambalotti, the world real interest rate peaked at close to 2.5pc around 1980, but it has been declining ever since, dipping to about 0.5pc in 2016, the last available year of data.

"A decline of this magnitude is unprecedented in our sample. It did not even occur during the Great Depression in the 1930s," the economists said.

Compounding the problem for central bankers is that they may no longer have a good idea of what level of interest rate is needed to keep the economy on an even keel and that the modern rules of central banking, which were crafted in the wake of the inflation shock of the 1970s, may no longer apply.

In a paper presented at a research conference in Boston this year, the grind to lower rates over the past 40 years to close to zero is likely to have had the impact of lowering the estimate of what the so-called 'neutral rate' which is the short-term real interest rate - the one set by central banks - that keeps prices stable when the economy is running at full capacity.

"In some sense lower rates beget lower rates," Piti Disyatat a research economist with the Bank of Thailand told the Boston conference.

This means that if central bank policy decisions also affect the neutral rate, its ability to act as a benchmark is undermined.

In other words, the central banks of the world may still have a roadmap, they just don't know which way is North.

The Federal Reserve sees its benchmark overnight lending rate at 3.4pc through 2021, its most recent forecast period.

Quite how far along that route the ECB will go is open to question.

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