A few weeks ago, Mario Draghi, the president of the ECB, and ECB member Weidmann confirmed the interest rates would continue at a relatively low level as this would be very helpful for the governments of Eurozone countries to get their finances back under control. This indeed seemed to be absolutely necessary to us, and in a previous column we already pointed out the devastating impact on the public finances should the interest rates on government debt increase by 1-2% on average.
Hundreds of billions of euro’s per year would have to be found to simply just cover the increased interest bill, without pushing through any fundamental changes. The low interest rate policy has been on the forefront for several years now, and after starting an asset purchase program, the ECB confirmed in 2016 that despite spending tens of billions of euros on asset purchases on a monthly basis, the interest rate policy would continue until after the asset purchase program ended.
This was confirmed a few weeks ago, but in a surprising move, apparently the European Central Bank did discuss a higher interest rate at the most recent meeting. And that’s quite surprising.
Source: Bloomberg
After all, why would one start to increase the benchmark interest rates if it’s still purchasing assets, which is a more direct way to impact the financial markets? After all, the ECB literally said it is reducing the asset purchase rate from next month on, by reducing the size of the program by 25%.
“ We continue to expect them [the interest rates] to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases. Regarding non-standard monetary policy measures, we confirm that we will continue to make purchases under the asset purchase programme (APP) at the current monthly pace of €80 billion until the end of this month and that, from April 2017, our net asset purchases are intended to continue at a monthly pace of €60 billion until the end of December 2017”
One of our main theories would be that once the ECB starts to increase the deposit rates, the health of the financial institutions in Europe would improve as they would no longer have to pay the ECB to park their money at the central bank.
Source: Bloomberg
This could actually be the only real reason for an interest hike, and the use of a ‘higher inflation rate’ as an excuse should not be accepted. After all, this is what the ECB statement literally says:
“This reflected mainly a strong increase in annual energy and unprocessed food price inflation, with no signs yet of a convincing upward trend in underlying inflation. Headline inflation is likely to remain at levels close to 2% in the coming months, largely reflecting movements in the annual rate of change of energy prices. Measures of underlying inflation, however, have remained low and are expected to rise only gradually over the medium term”
Read the previous quote again, slowly. There are NO signs of underlying inflation. It didn’t say there were ‘few’ signs or ‘some’ signs, no, there are NO signs of underlying inflation, and only the ‘headline’ inflation is moving. And we have a certain feeling the word ‘headline inflation’ will become more common now.
But it all boils down to one thing. Did Mario Draghi lie? Will we see a rate hike before winding down the asset purchase program? And why so? The next few weeks and months will be very interesting on this front, and should the ECB indeed be planning to step up its interest rates, you can be sure you will see board members hinting at it in the media the next few months.
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