Mar 11, 2016 | 02:47 GMT

6 mins read

In Europe, the Central Bank Loses Control

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

Gone are the days when European Central Bank President Mario Draghi could bend the markets to his will merely by uttering three words. His vague promise to do "whatever it takes" to save the euro, made four years ago, was enough to avert the unraveling of the eurozone at the hands of bond investors. On Thursday he unveiled a raft of measures designed to weaken the euro while at the same time propping up the Continent's ailing banking sector. These included an interest rate drop further into negative territory, a sizable increase in the rate of bond purchasing in the ECB's quantitative easing program, and a new package of ultra-cheap loans for the banking system. These measures, by contrast, have not achieved the same success. 

In the first endeavor, he failed in somewhat spectacular fashion: The initial reaction to the rate drop was good, as the euro plummeted by 1.3 percent against the dollar, but it then abruptly reversed direction and rose 3 percent at an equally urgent pace, finishing 2 percent higher than where it began. Meanwhile, on the success of Draghi's second measure — providing cheap loans to aid eurozone banks — the jury is still out. Italian banking stocks, the Continent's most troublesome, experienced the same rollercoaster as the euro, only inverted. They rose sharply by 7 percent before rapidly falling back to earth once more. Nevertheless, Italian banks did finish the day up 1.56 percent, suggesting the market was broadly more positive about Draghi's banking moves than about his attempts to manage the euro.

The euro's wild ride brings to mind a similar episode that took place in January; that time the instigator was Draghi's Japanese counterpart, Haruhiko Kuroda. Like Draghi, Kuroda had been trying to weaken the yen using negative interest rates. And, like Draghi, the currency traced what is known as a J-curve, dipping first before surging back to finish far above the level at which it had begun the day. In Kuroda's case the problems were magnified by the fact that his program did not include the same cheap banking loans, meaning that Japanese banks also experienced steep falls in their share prices.

The question across the Eurasian continent, then, is this: What exactly is going on? Ever since the financial crisis, global markets have been greatly determined by central bank actions and interest rate drops. And quantitative easing programs have been obsessively anticipated, discussed and number-crunched. For example, it is hard to imagine a 33 percent rise in the rate of bond purchases, one of Draghi's new measures, achieving such meager results had it been announced a year ago. Central banks have now been disregarded twice in two months, leading many to ask whether they have reached the end of their effectiveness.

In the case of the Bank of Japan, that may very well be true. The Bank of Japan has been buying bonds for many years, and if it continues buying at current rates it will own 60 percent of the total supply by 2019. Thus, in the Japanese case, resorting to negative interest rates could have been interpreted as evidence that more quantitative easing was not possible, giving the impression that Japan was fast running out of options. The ECB, by contrast, didn't begin its quantitative easing program until 2015. And unlike the Japanese example, it changed its own rules and increased the pace of purchases, which could hardly have been seen as a sign of limitation.

Perhaps, though, the limitations are not within the central banks in question. Perhaps they are instead in the markets themselves. The values of currencies are all relative to each other, meaning that they cannot all move up or down at the same time. And in today's global markets it is hard to find a currency that is not under downward pressure. The Chinese yuan, pegged to the dollar for so long, is now decoupling by stages, as a mixture of capital flight and loan repayments drive its value inexorably downward. Large sections of the emerging markets, linked to commodity prices and to China's economy, are still suffering economic hardships as their revenues dwindle. The United Kingdom, which had been one of the world's brighter economic spots for the past 18 months, is now seeing its currency significantly weaken because of the danger of a "leave" vote in its forthcoming EU in-out referendum.

One currency that is strengthening is the U.S. dollar, almost alone, but even it shows signs of weakness. In December 2015, there was a long-awaited rise in U.S. interest rates following an extended period of healthy domestic economic indicators, but 2016 began with considerably less positive data, and it is only in recent weeks that the markets have again come to consider the possibility of another rate hike happening in the coming months.

With so many currencies naturally weakening it is unsurprising that attempts by the ECB and Bank of Japan to artificially weaken their respective currencies have proved futile. Both central banks represent historically strong economies with strong current account surpluses. (The fact that they export more than they import creates a demand for their currencies that drives them upward naturally.) To put it bluntly: With every currency falling naturally, it is becoming much harder to fake it.

The upshot of this is that the European Central Bank is likely to become more aggressive and unconventional in pursuit of its 2 percent inflation target — currently at 0.3 percent — and a weakening of the euro might just help achieve it. In the news conference today, Draghi was asked about "helicopter money," a highly unconventional tool that would involve the central bank putting money directly into the hands of the general public rather than with commercial banks, which is what happens with quantitative easing. This is one way to stimulate spending and thus inflation. Draghi responded that it was not something the Governing Council had yet considered. However, given the minimal effect that his announced policies had on the market, it is likely that the council will have to start considering it very soon.

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