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Mario Draghi Shows the Power of Expectations

Last Thursday, ECB President Mario Draghi said the following:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The response was euphoric – stock markets railed, risk premiums on the Eurozone periphery fell, and the Euro strengthened – and demonstrated that expectations matters. Without actually doing anything, the ECB was able to catalyze a shift in portfolios toward riskier assets that, if followed through, could kickstart a recovery. It is what Matt O’Brien calls the Jedi mink trick or Nick Rowe dubs the Chuck Norris approach to central banking. This power by central banks to manage expectations is often overlooked or dismissed by many observers. The markets’ response to Draghi’s speech should give them pause.

Now the power of expectation management is nothing new. It is the reason FDR was able to spur a rapid recovery in 1933. It is also why some Fed officials are now promoting an open-ended form of QE. Finally, it also why Market Monetarist have been calling for nominal GDP level targeting for some time.

If you still have doubts on the power of expectations management, imagine this counterfactual scenario. Mario Draghi in his speech last Thursday comes out with a large chart behind him that looked like this:

He then says the following:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And for the ECB this means closing this large gap between actual and trend nominal GDP. This gap is simply unacceptable. We are now committed to closing it. And believe me, what the ECB does will be enough.

Imagine how much greater the response would be to that bold message. The economic outlook would instantly improve, portfolios would be adjusting even faster, balance sheet and wealth effects would kick in, and a recovery would be put in motion. This would not end the need for structural reforms in Europe, but it would vastly improve government balance sheets and cause the private sector to do most of the heavy lifting in the recovery (i.e. the ECB would not need to buy vast amounts of assets).

The stakes are high. As Ambrose Evans-Pritchard notes, we are on the cusp of another global economic crisis and Mario Draghi is the one individual who could prevent it. All he needs to do is don his Jedi or Chuck Norris outfit. Putting those outfits on would be a lot easier if the ECB adopted a nominal GDP level target.

P.S. Imagine how expectations would change if the FOMC came out with press release like this one at their next meeting.

This post originally appeared at Macro and Other Market Musings and is posted with permission.

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Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He also has an extensive academic background, serving as Professor of Economics at the University of Sao Paulo and University of Campinas (UNICAMP) in Brazil.

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