The Raw Power of the Dragh

Forget the “Bernank”. The “Dragh” is a true force of nature.

To ask monetary policy to cure all ills—from labor markets to animal spirits—is kind of silly. Silliness doesn’t stop the pining.

What one can reasonably expect of domestic monetary policy is an impact on nominal levels in local currency terms. This is because there is no private sector substitute for the bank rate (in the US this is Fed funds). Inflation expectations are the connection between nominal levels which a central bank can directly influence and the real levels that it can only indirectly influence. Thus the real challenge for the ECB is to craft monetary policy in such a way that it causes nominal levels to converge in spite of national economic differences.

Draghi looks like the proverbial maestro at this point, because he has done it. Inflation expectations in Spain have moved from pricing deep deflation to around 1% inflation. At the same time, German inflation expectations have stayed at this modest level. So you have periphery expectations convergence to core expectations. And you did this without either one blowing up.

Inflation expectations are defined with the implied breakeven. This is the spread between a country’s sovereign bond yield and the yields on that country’s linkers. As such there are always differences in the liquidity of these instruments (nominal bonds being more liquid) and other technical considerations that influence this spread in small ways. What you see is a triumph of central banking.

How did he engineer this? Simple. Real money took ECB QE as a cue to leverage up on the periphery sovereign bonds as risk-free money: from the short end to the belly of the curve to the long end to linkers. Everything. Corporate bonds hit a bid too, but nothing comparable to the sovereign compression trade.

In this is an indication of the weakness of the plan. It shores up sovereign finances directly, but leaves corporate financing only indirect benefit. But this shouldn’t detract from his achievement. The effects are wide-ranging. First, it anchors inflation expectations consistently across the Eurozone. Second, it shores up the asset side of periphery balance sheets, especially collateral values necessary to leverage risk-taking. Third, it places longer-term political integration on firm footing. Not bad.

Would Draghi prefer a higher nominal rate? Sure, I think the target is 2%. I’m not complaining about his temperate and modest approach.

People can and should note labor market weakness, income inequality, and general unfairness in outcomes. Fair enough. But this is a cosmic problem, not a problem of central banking. Don’t blame the maestro.

Instead just shut up and take advantage of the opportunities. Carpe Diem, boys.


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