Why the ECB's U-turn has panicked investors

190308-ECB — Mario Draghi of the ECB: the toughest job in central banking

Mario Draghi is currently the head of the European Central Bank (ECB). Of all the world's central bankers, I think it's fair to say that he's had by far the toughest job during his time in charge.

He's stepping down later this year. And he had probably hoped to get out of the door with the sense of "mission accomplished" that raising interest rates might have given him.

Unfortunately, that's no longer an option.

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Indeed, by the time he's emptying his drawers, we might even see more money printing in the eurozone.

The toughest job in central banking

Being the person in charge of eurozone monetary policy is nothing like being the head of the Bank of England, or the Federal Reserve, America's central bank.

Mark Carney and Jerome Powell only have to worry about setting interest rates for one group of constituents. And there is almost always a consensus view for rates to go lower and for policy to be looser. That's not necessarily a good thing, but it does make their lives pretty straightforward.

But if you're the head of the ECB, you've got one very powerful country that wants interest rates to be higher Germany and then there's most of the rest of them, whose economies really need a weaker currency and a much more forgiving cost of borrowing.

You also have to cope with the fact that the underlying currency you are meant to be managing and safeguarding could break up at any point if you fail to balance the demands and needs of these constituencies effectively.

There's also the problem that unlike the central banks in other countries you are much more limited in terms of your ability to single out and prop up individual financial institutions that might be systemically important.

In effect, central banks in most countries are allowed to carry out redistribution of resources by the back door. This is meant to be something that only democratically elected governments do (hence the somewhat fictitious split between "fiscal" and "monetary" policy).

But quantitative easing (QE) and bailouts involve taking resources from one group and giving them to another. So it is redistributive it's just that the redistribution consequences are not obvious or immediate.

The ECB, however, can't do that (at least, not to the same extent). One group of British people can be penalised in order to bail out another group of British people (although the consequences of that are now being seen at the ballot box). But you can't coerce German citizens into shelling out for Greek ones (to take the classic example).

This problem of having one currency zone but not one political zone has had two major effects on the eurozone.

Firstly, it is well behind the US and the UK in terms of cleaning up its banking system, because so many of the problems remained swept under the carpet. As a result, the wider economy arguably remains more vulnerable to ongoing jitters in the financial system.

Secondly, Draghi who certainly appears to be an unusually effective technocrat has had to expend most of his energy simply getting the green light to go ahead with the likes of QE in the eurozone. He's put a few mechanisms in place that should allow his successor to loosen monetary policy with less of a fight in the future, but that's about it.

Here's what really freaked investors out the strengthening dollar

Anyway, so on that front the eurozone has been looking a little wobbly recently, like everywhere else in the world.

Until yesterday, the ECB had been putting a brave face on it. They had been hoping to keep on the road towards tighter monetary policy.

That's not the case anymore. At yesterday's meeting, they pulled a full-on, Federal Reserve-style U-turn.

For a start, the ECB downgraded its growth expectations for the zone from 1.7% to 1.1%. Secondly, it said that it won't be raising interest rates until at least next year (which ties the hands of whoever inherits the throne from Draghi given that it could be someone rather more hawkish, that's probably a big part of the plan).

But the biggest move was that the ECB launched another round of TLTROs. I'm not going to bother spelling out this unwieldy acronym all it means is that troubled eurozone banks will be able to borrow money direct from the ECB, as long as they lend it out to companies. And because the ECB's interest rate on that money is currently sitting at -0.4%, it means they get paid for taking the loan.

So the life-support mechanism for the more dodgy banks in the eurozone has been pushed back into place, which gets rid of one big worry that was coming up later this year (a lot of loans from earlier rounds of TLTRO were falling due).

On the one hand, this is bullish, because hey the more money-printing the better, right? Well, yes, but clearly there's a snag, because markets fell on the news and they're still falling today.

Is it because, as some papers have suggested, Draghi's dramatic U-turn has freaked markets out? Are they shocked at the idea that the eurozone might be in trouble?

I suspect not. I think the real issue is a bit more technical than that. The problem is that the downbeat outlook sent the euro down. Trouble is, a weaker euro means a stronger dollar. And a stronger dollar is not at all good for global liquidity as a whole particularly not for emerging markets.

The Fed is, of course, aware of this. And now that all of the global central banks have cracked, if the market also turns down again, expect to see more action from the US to try to weaken its own currency.

It looks like we're back in the race to the bottom. Good old "currency wars" are about to make a comeback. Probably not a bad time to make sure you have some gold in your portfolio. (Financial historian Russell Napier explains why that's a good idea in the latest issue of MoneyWeek magazine, out today subscribe now if you haven't already).