Should We Believe Draghi?

In the much-anticipated European Central Bank (ECB) rate statement held on Thursday, ECB President Mario Draghi announced that policymakers voted unanimously to hold interest rates at 1.0%.

According to Draghi, members of the ECB decided to sit on their hands because they’re willing to wait a bit longer for their strategy to do its magic. Actually, he claims their decision to use a long-term refinancing operation (LTRO) has already started to work, and there is a bit of evidence to support this.

If you recall, the ECB recently launched a three-year long-term refinancing program to lend money to banks to kick-start the economy. Draghi and his men were hoping that banks would use these affordable funds to loan out to other banks and businesses, thereby increasing economic activity.

They were also hoping that this would lead banks to buy sovereign bonds, and the successful bond auctions in Spain and Italy on Thursday suggest that some banks may be doing just that.

But on the other hand, critics say that the ECB’s move hasn’t been effective, and they’ve got the studies to prove it, too. A report published in late December revealed that although banks loaned a record amount from the ECB (489 billion EUR) last month, they’ve been hoarding their newly acquired funds instead of injecting it back into the economy.

Basically, they’ve been borrowing money from the ECB only to reinvest it in overnight deposits with the central bank!

Draghi has responded by saying that the banks that borrowed money from the ECB aren’t the same banks that have been redepositing money into the central bank’s deposit facility. But does it even matter which banks in particular have been doing this?

The fact that there are banks out there (and plenty of them, at that!) who’d still rather reinvest their funds in the central bank’s very low interest rates than loan it out for better returns is a red flag on its own, at least in my book. It just goes to show that confidence is still at a low and that the ECB’s loan program may not be getting its intended effects!

Another interesting detail is how Draghi noted “tentative signs of stabilization.” Last time I checked, retail sales, industrial production, manufacturing activity, and services activity in the euro zone were still on the decline! Could it be that Draghi’s only seeing things through rose-tinted glasses?

I guess the point that I’m trying to drive across is that we can’t always take what policymakers have to say at face value. After all, their optimism, whether due or not, won’t do much to affect the poor outlook for growth this year.

No matter how you look at it, European governments will still have to take on drastic austerity measures, and this will weigh down the economy in the coming year. The way I see it, the euro zone is still in the same boat – one that’s slowly taking in water… so don’t be surprised to see the euro continue sinking!

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