ECB promises are worthless

draghi

There has been much discussion about whether the ECB has tapered or not. They have reduced the size of their monthly purchases but extended them until the end of the 2017 rather than the expected 6 months from March, so that the promised total of asset purchases is actually greater than had been expected (the market was looking for a promised 6 months of EUR80bn = 480bn but they have 9 months of 60bn = 540bn). But this is still a tapering. Why? Because promises are worthless.

The ECB’s “guarantee” that purchases will be at least 60bn a month for at least 9 months is no such thing. Of course, they are very likely to stick to the letter of this promise, but if circumstances changed so that a tightening of monetary policy was necessary, would they really choose not to enact one? How irresponsible would that be? If they did fail to respond to the need to tighten the markets would react anyway. Anticipation of higher inflation would lead to substantially higher bond yields regardless of whether the ECB chose to continue with a policy that is clearly misguided.

There is a clear logical problem with the ECB (or any other central bank) making promises about future policy while at the same time pledging to stick to its remit of hitting its inflation (or any other) target. While in practice it is unlikely to have a problem sticking to its promises, that is because the promises are well within the range of policy options that they would design to hit their targets under normal circumstances. Had the ECB chosen to go with 80bn a month for 6 months, the odds are they would have extended this again beyond 6 months, probably with smaller volume, since even Draghi has admitted that they are unlikely to stop their asset purchases dead, but  rather taper off. But unexpected things can happen, and if they do the ECB may be forced to renege on their promises. If a tightening in policy is necessary, they might choose a different method and thus stick to the letter of their promise, but the promise itself is still valueless if there are circumstances in which the ECB would renege, whether in spirit or in letter.

The market has chosen to accept Draghi’s protests and not see the taper as a taper. But it is a taper. Future policy promises are worth nothing because central banks will do what they perceive is right at the time, and will effectively override any policies they have committed to if circumstances demand. It is time the markets stopped taking notice of this nonsensical approach of promises. Forward guidance is one thing – providing an idea of what they expect to do – though events have shown even this is wrong often enough to have very limited value. Promises are a step too far, and imply either omniscience  – so that there can never be a need to renege on a promise – or irresponsibility – with central banks prepared to sacrifice correct policy to stick to a promise they made under different circumstances. Central banks are not omniscient, and should not be irresponsible – so promises of this short are worthless and worse, potentially damaging.

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