ECB’s no-drama Mario Draghi unlikely to take heroic measures

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Resolutely independent, the European Central Bank is supposed to be immune to politically motivated, economic fix-it pleas of the 18 countries that share the euro. Still, it is hard to imagine that ECB president Mario Draghi can ignore the political earthquake triggered by the European Union parliamentary elections.

The May 25 election delivered about 30 per cent of the vote to Euroskeptic parties on the far right and far left of the political spectrum. The biggest shock came in France, where Marine Le Pen's anti-euro and anti-EU Front National won 25 per cent of the vote, pushing the socialist government of President François Hollande into distant third spot.

On the day after the election, Mr. Hollande called for a new EU strategy to overcome the populist surge. Enough with austerity, he said; what was needed were "jobs, growth and investment." As if to prove the point, the French labour minister reported two days later that France's jobless rate had nudged up to a record high, with 3.36 million out of work.

Since Mr. Hollande took office in May, 2012, the number of unemployed in France has climbed by 440,000, taking the jobless figure to more than 10 per cent.

Mr. Hollande would, of course, be delighted if the ECB on Thursday – its next policy meeting – were to unveil a package designed to juice up the euro zone economy and fight declining inflation. After sitting on the sidelines for the past year, save for a quarter-point interest rate cut in the autumn, Mr. Draghi is expected to do just that. The question is whether any stimulus and easing measures he announces will be too little, too late.

Inflation in the euro zone has been falling since late 2011, and was last measured, in April, at 0.7 per cent, nowhere near the target level of close to 2 per cent. More than three quarters of the EU's 28 countries have inflation rates of 1 per cent or less and seven of them, including Greece and Portugal, have outright deflation – falling prices – which encourages consumers and businesses to delay purchases.

To be sure, the overall euro zone economy is improving. , even if at least one of its big economies, Italy, was back in contraction territory in the first three months of the year. But overall growth is so weak that the jobless rate, while no longer rising, seems stuck at close to 12 per cent. Unless growth picks up to the point it soaks up some of the labour and manufacturing slack, inflation is bound to stay low for a long time.

Mr. Draghi has not been a man of action in recent months, even though the growth and inflation numbers are not to his liking, or to the liking of the prime ministers and finance ministers in the flat-lining euro zone countries. His strategy has been to try to talk down the value of the euro to prevent deflation from setting in. For the most part, it has not worked.

At the ECB's last rate-setting meeting, in May, Mr. Draghi in effect admitted that his hold-the-course strategy was failing. "The governing council is comfortable acting next time," he said, subject, to the inflation forecasts that are to come out in early June. His apparent surrender reversed the course of the euro. Before the ECB's May policy meeting, it was headed to $1.40 (U.S.). Since then, it has fallen to about $1.36 on the expectation that disinflation-busting schemes are imminent.

A surprising uptick in German unemployment and weak lending to businesses has strengthened the case for the ECB to swing into action. With Chinese growth tapering off, the fear is that the German export machine will lose momentum. "German export orders need to be watched," said Steen Jakobsen, chief economist and investment officer of Denmark's Saxo Bank. "We are nearing the zenith in growth, export and production coming from the overoptimism which kick-started the year. Reality is close by."

Few economists expect the ECB to do anything truly dramatic on Thursday. According to a Nomura client survey, the refinancing and deposit rates will almost certainly be cut, probably by one-10th of a point, taking the latter into negative territory. The deposit rate is interest paid to the banks which store cash at the ECB overnight. A negative fee theoretically would encourage banks to make better use of their cash, like lending it out.

Most of the Nomura clients expect some sort of liquidity injection into the financial system, with another dollop of cheap loans to the banks emerging as the leading option. The ECB's last big bank liquidity injection, a 36-month issue, came in early 2012, and was designed to prevent interbank lending and loan origination from drying up.

What seems unlikely, at least on Thursday, is outright, U.S.-style quantitative easing, where the ECB would in effect print money through the purchase of asset-backed securities, corporate bonds and sovereign bonds. A bare majority of Nomura's clients, however, expect the ECB to announce some form of quantitative easing later in the year.

Will it work? Normura economist Jens Nordvig said that Normura's central case is that a rate cut, combined with another round of cheap loans, "would likely deliver little direct market impact on rates or the euro. The crucial bit is whether the ECB is able to hint at future [quantitative easing]."

There is no doubt that the ECB kept the euro zone intact during the height of the crisis in 2012. The next challenge is to get the economy growing and inflation moving up. The leaders of countries, like France, where the populist parties are rising, will be praying that Mr. Draghi doesn't let them them down.