Markets deluded by Draghi’s decision

Over the past weeks market participants in Europe were expecting further stimulus by the European Central Bank (ECB). In the build-up to the meeting, European indices registered remarkable gains. The expectations came about following the remarkable easing measures by other central banks which pushed the Euro higher over the past days. However, Draghi failed to deliver and markets reacted negatively.

Expectations were that the ECB might extend the deadline on its quantitative easing program by six months, while interest rates would remain intact. This has led to tighter yields within the fixed income market, while equities continued to recoup their year-to-date losses.

Draghi’s slightly dovish talk is being reflected within the economic growth forecasts for 2017 and 2018 presented in yesterday’s meeting by the ECB. In fact, the ECB raised its economic growth outlook for the euro zone slightly for 2016, but cut it for 2017 and 2018. It now sees growth in the 19-country bloc averaging 1.7 percent this year, having previously forecast 1.6 percent growth. It forecasts expansion of 1.6 percent in 2017 and 2018, down from its June forecast of 1.7 percent in both years. While the central bank's 2016 inflation forecast was held at 0.2 percent and its 2018 estimate stayed at 1.6 percent. However, it cut its 2017 forecast to 1.2 percent from 1.3 percent.

As I have opined in my previous articles, despite QE being be an effective measure in stimulating economic growth, the extent to which it is beneficial to the economy will be only known in the future looking back at economic data. One must re-call the fact that signs of effectiveness of QE in the U.S. were seen following the implementation of three QE programs which span over a number of years.

Other than that the situation in Europe might be also difficult to compare due to the lack of fiscal consensus amongst major economies. In yesterday’s press conference Draghi continued to stress the need for action in terms of fiscal expansion primarily by Germany.

Despite the fact that in my view short-term effectiveness can be achieved through a combination of fiscal and monetary stimulus, the possibility of fiscal expansion is very unlikely. Fiscal expansion initially comes at the expense of higher debt-to-GDP ratios. Over the past years the European Commission has implemented severe measures on European Governments to reduce their debt levels, which led to lower spending by major Euro area Governments.

Looking at the numbers, the levels of debt-to-GDP are quite concerning. How could for instance Italy, the third largest economy in Europe, increase its expenditure when its debt-to-GDP levels are currently circa 132.7 per cent? Not to mention other economies which are at a similar situation.

Moving forward, I would expect further easing measures at the next ECB meeting. In terms of effectiveness, easing measures currently are solely pumping up asset prices, but fundamentally nothing yet have changed. If the ECB wants to be instantly effective, is it time for the so-called theoretical ‘helicopter money’ measure?