Draghi stays out of the sandbox while others play on


European Central Bank President Mario Draghi says to wait and see. (Photo by Hannelore Foerster/Bloomberg)

If Mario Draghi was a kindergartner, he’d be sitting outside the sandbox watching the other kids get dirty. At a high school dance, he’d be the loner against the wall.

From Janet Yellen at the Federal Reserve to Raghuram Rajan in India, the world’s central bankers have entered an active phase – shaping strategies and buying bonds and hiking interest rates (and even arguing in public!) to mold a post-crisis monetary policy. Faced with massive unemployment in some parts of the euro zone and an acknowledged threat of deflation, European Central Bank president Draghi on Thursday announced that the ECB's response would be…to wait for more data.

“We want to see clearly through the present uncertainty,” Draghi said after the bank board announced it would not cut interest rates or take any other action until more information clarifies whether the euro zone is actually falling off a cliff or simply on the verge of it. “It is important to analyze information before taking decisions that will have an effect for a protracted period of time.”

The decision leaves the ECB as the odd man out, still unable to fully resolve the political strains between its dominant German constituents, where the economy is doing just fine, and battered nations where wages are falling and joblessness at seemingly dangerous levels. This is at a time when changes in U.S. Federal Reserve policy and a round of turmoil in emerging markets have been driving down world stock markets and raising speculation about the risk of a new crisis.

This has consequences for the United States. Europe’s recovery is, to some extent, America's recovery, too: Growth of 1 percent in perpetuity would not be great at the center of the industrialized world. After a 2013 in which Europe was kind of forgotten as a drag on the world, America continued its rebound and there was optimism about solid global growth, doubts are creeping in.

The analysts at the Institute of International Finance have dubbed 2014 the “year of validation” – when companies and countries are going to have to prove that their growth rates or stock prices are warranted and not just smoke and buybacks. As the charts below show, the projected path of corporate earnings in Europe is not in line with stock prices; among developing countries, it did not take much of a push for investors big and small to go elsewhere.


Expected earnings are below stock markets in Europe. (Source: IIF, Bloomberg)

Which is partly why in recent weeks central bankers in a lot of those places have been raising interest rates at a sometimes furious pace – to stay attractive to outside investors, tame inflation as local currencies fell in value and  try to stay ahead of the transition from crisis-based monetary policy to something more normal.

Japan is fighting its own peculiar battle for growth, putting Bank of Japan governor Haruhiko Kuroda at center stage, while in the United States, Yellen is navigating the end of quantitative easing.

Europe, meanwhile, remains a muddle, and the ECB’s meeting this week gave little direction.

Smart people like to use Latin words for simple concepts. Economists use the word “hysteresis” to describe the fact that complex systems can get stuck in a rut, like having a giant muffin and a whole milk latte every morning even after it has become obvious that you have a giant muffin and whole milk latte every morning. Hysteresis means that when unemployment, for example, spikes to unnatural levels there is a risk that the economy sort of becomes used to it, and it therefore becomes harder and harder to nudge it back down.

In Europe, unemployment is 12 percent regionally, higher in crisis countries like Greece, and has been stuck there for a long time. Growth is low and may be ebbing. Even inflation – the ECB’s touchstone “mandate” indicator – dipped in January to 0.7 percent, well below the 2 percent target and low enough that Draghi acknowledged the risk of deflation.

Prices can rise too fast and erode the value of money. Falling prices and contraction can also be bad: It makes a given level of debt that much more onerous in real, “deflation-adjusted” terms, and can lead to falling wages and lower spending.

As it stands “these levels of inflation for a protracted period of time are a risk by themselves,” Draghi said. “They are a risk for the weight of debt. They are a risk for a variety of reasons. We are alert to these risks and we stand ready and willing to act.”

Just not yet.

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Howard Schneider · February 6