EUROPEAN CENTRAL BANK PRES DRAGHI PROMPTS ROLLERCOSTER RIDE

It has been previously noted that markets respond well to central banks as politicians have mostely lost all their credibility. Last week another example of how policy makers can influence financial markets. When the European Central Bank (ECB) President Mario Draghi spoke on July 26 at an investment conference in London and hinted of potential easing, markets across the globe soared. The euro common currency gained 60 per cent last week closing at $1.23 on Friday. The ECB president used strong words last Thursday, which were well received by the markets: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. He also noted that if too high sovereign bonds yields are disrupting the policy transmission of the ECB, it would be in its purview to address the problem - a welcome hint which resulted in lower peripheral bond yields. These deliberately vague remarks prompted economists to speculate that the ECB will use unconventional measures such as quantitative easing (QE). The traditional methods would be extending the Securities Markets Programs (SPM) in which the central bank buys, for example, Spanish and Italian bonds and sell German bonds without an expansion of its balance sheet. This would bring down the yields on Spanish and Italian bonds. Another option would be launching long-term refinancing operation (LTRO) where banks could pledge shorter-dated sovereign bonds as collateral for cash at the ECB for the duration of three years. At the beginning of the year the central bank had already expanded its balance sheet by 1 trillion euros ($1.23 trillion USK) through this method. Both of these methods are different from QE that the Federal Reserve undertakes. LTROs came at the cost of saddling the banking systems with large holdings of government securities. QE would see the ECB increasing its portfolio of "peripheral" bonds and the banks enjoying a welcome liquidity injection.