Draghi Won’t Be Stymied By the Limitations of Monetary Policy

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European Central Bank President Mario Draghi devoted his Tuesday speech in Jerusalem to the limitations of monetary policy — a topic that “has attracted a great deal of attention since the beginning of the financial crisis.”

He began by saying that “circumstances have forced all major central banks to resort to instruments and policies carefully tailored to the unusual situation.” The 17-member euro zone is experiencing its longest recession ever — in the first three months of the year, gross domestic product fell 0.2 percent and unemployment hit at a record high. So Draghi has decided to consider non-standard monetary policy tools and will deploy them if the circumstances warrant.

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“We will look with an open mind at these measures that are especially effective in our institutional setup and that fall within our mandate,” Draghi said. “Some of those measures may have unintended consequences. This does not mean that they should not be used, but it does mean that we need to be aware of those consequences and manage them appropriately.”

The unusual measure that Draghi is considering is charging lenders to hold cash at the Frankfurt-based central bank by introducing a negative deposit rate. Since last July, that rate has been at zero. The ECB is also reviewing further long-term lending operations and adjusting collateral requirements to handle the abysmal economic conditions.

“There are numerous other measures – standard interest rate policy and non-standard measures – that we can deploy and that we will deploy if circumstances warrant,” Draghi added.

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Following his speech, the euro fell as much as 0.3 percent to $1.326. It later reversed its decline to trade at 1.339, an increase of 0.2 percent, just after 10:30 a.m. in Frankfurt. Despite the long-lasting recession, the euro has strengthened 1.5 percent against the dollar so far in 2013 and gained 4.5 percent overall, the most among 10 developed-market currencies, according to Bloomberg’s Correlation-Weighted Indexes. The euro’s rise this year means that at least some investors believe that the measures taken by Draghi and government officials are enough to hold the currency union together. But it does threaten the ability of member nations to use exports to boost economic activity and end the six quarters of economic contraction.

While the central bank does not formulate policies targeting the exchange rate, Draghi has said that it is “important for growth and price stability.”

Demand in the euro zone should benefit from central bank policy, as well as low inflation, strengthening consumer confidence, and wealth effects from gains in financial markets, Draghi said. However, he did note that the ECB’s Governing Council has stressed that “monetary policy will remain accommodative for as long as necessary and let me say very clearly: we are far from any exits.” After all, as Draghi said, the central bank’s mission is to save the common currency.

“In the period ahead, we will monitor very closely all incoming information on economic and monetary developments and stand ready to act if necessary,” he said.

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One positive Draghi noted was the effect of the ECB’s Outright Monetary Transactions bond-purchasing program. It has yet to be used, but it has caused a significant decline in financial market tension, he said. In setting up the banking union, the European Union is moving toward a longer-term solution to the crisis, Draghi added. The union “should provide an answer to many of the challenges currently facing the euro area, including uneven credit conditions and the fragmentation of financial markets,” he said. “Much work remains to be done for economic policy makers across Europe. Reforms need to continue.”

Here’s how the major U.S. stock indices finished trading on Tuesday:

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