Mario Draghi's silver-tongued eloquence isn't working like it used to - at least to judge from money market rates.
The European Central Bank chief, who wowed investors with his vow a year ago to do "whatever it takes" to save the euro, has been unable to steer down market interest rates as much as he would like despite giving 'forward guidance' on policy.
Responding to market volatility that set in after the U.S. Federal Reserve in June set out a plan to begin slowing its stimulus, Draghi pledged in July to keep ECB interest rates at record lows for an extended period of time.
The guidance was a major step, breaking with the ECB's tradition of not pre-committing on policy. At his August 1 news conference, Draghi said expectations of rate hikes in money markets were unwarranted – a clear warning to markets.
But his verbal intervention had little impact. Two-year forward EONIA overnight rates are up 25 basis points since mid-May, and are only 5 basis points below their peak in late June, before the ECB unveiled its forward guidance.
Expectations about the ECB's rate moves are not the only factor at play in determining market rates. Their rise is also influenced by dwindling excess liquidity - the level of cash beyond what banks need to cover their day-to-day operations.
Another ultra-long-term funding operation, or LTRO, could be the ECB policy option with fewest side effects to counter the tightening liquidity situation. ECB staff have already discussed the idea as an option with outside experts at a regular meeting.
"The increase in EONIA forwards reflects expectations of a lower liquidity surplus rather than policy rate hikes," Barclays economists Giuseppe Maraffino and Laurent Fransolet wrote. "Greater clarity about the liquidity outlook is needed for EONIA to decline."
TIGHTENING BY STEALTH
In late 2011, early in his term as ECB president, Draghi opened the liquidity spigot to ensure banks had access to funds as interbank markets were drying up due to a lack of confidence.
The ECB funnelled over a trillion euros to banks with twin three-year liquidity operations, lifting excess liquidity to more than 800 billion euros early last year.
Early repayment of those loans has cut excess liquidity to some 250 billion euros - not far from the 200 billion level the ECB has said may be the point when market rates start edging up toward its main refinancing rate, now at 0.5 percent.
Draghi has welcomed the early repayments as a sign of confidence and improved funding conditions, although many lenders in peripheral Europe are still dependent on ECB funds.
But the repayments are making the central bank's monetary policy less accommodative, and it may be forced to counter this quiet tightening by other means.
"Early repayments could ... be expected to have a potential to change market expectations of future excess liquidity and thereby affect the money market term structure," the ECB said in its July monthly bulletin.
Banks return money to the ECB every week, but with lower repayments in recent weeks, the central bank can afford to wait until taking new measures.
LTRO LEAST BAD OPTION
The ECB has several options to try to bring down forward rates. The most obvious would be to cut the main refinancing rate to 0.25 percent, which Draghi has said it has room to do.
That would push down the short end of market rates but narrow the differential between the refinancing rate, the deposit rate the ECB pays on bank deposits, and its overnight lending rate. That could reduce banks' incentive to lend to each other and threaten a tenuous recovery in interbank markets.
Cutting the deposit rate into negative territory from zero would take the ECB into uncharted waters and would burden banks by effectively charging them for holding money at the ECB.
Outright asset purchases could be effective, but the central bank has reserved them for use in case of serious deflation risks, making such a move hard to justify after the economy grew for the first time in 1-1/2 years in the second quarter.
"The ECB is likely to be ready for quantitative easing only if deflation, in the narrow sense of the word, is feared," Commerzbank economist Michael Schubert said in a note.
The ECB could also stop taking weekly deposits to offset money injected into markets via its Securities Markets Programme bond-buying plan. This "sterilisation" of bond purchases was introduced to stave off inflation fears, however, and could be seen as the ECB veering away from its mandate.
It could also firm ECB forward guidance by promising not to increase rates no matter what, but hawkish policymakers such as Bundesbank President Jens Weidmann might object.
The remaining option is another long-term liquidity operation for banks, which are preparing for an asset quality review and stress tests to be finished by next autumn.
It might even offer a sweetener. Minutes of a July meeting of the ECB's Bond Market Contact Group, comprising ECB staff and finance experts, show it discussed "creating a special 3-year LTRO similar to the Bank of England's Funding for Lending Scheme where cheaper funding would be provided to banks".
The central bank could also choose to use such an LTRO to bolster its forward guidance.
"The ECB could decide that the (LTRO) interest rate can be adjusted downwards, but not up - the current 0.5 percent rate would not be exceeded," Commerzbank's Schubert said. "This would give a clear signal of low rates for a long time."
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