Draghi gets a grilling, defends cheap loan program

The President of the European Central Bank (ECB), Mario Draghi, stepped into the spotlight again on Monday, as he testified in front of European policymakers amid renewed concerns of deflation and questions regarding the effectiveness of his policies.

"The economic recovery in the euro areas is losing momentum," Draghi told the Committee on Economic and Monetary Affairs. "The early information on economic conditions which we received over the summer has been somewhat weaker than expected."

He also defended the take-up of the ECB's latest cheap loan program, dubbed TLTRO or targeted longer-term refinancing operation. Last Thursday, the ECB doled out 82.6 billion euros ($106 billion) in loans to banks—an amount which was viewed as disappointingly low by markets.

Draghi insisted: "This is within the range of take-up values we had expected... By design, the September and December operations should be assessed in combination."

Another round of cheap loans will be offered in December.

Read MoreECB doles out cheap loans to banks, fuels QE hopes

Mario Draghi, President of the European Central Bank
Sean Gallup I Getty Images
Mario Draghi, President of the European Central Bank

Draghi also defended Blackrock's role as an adviser on the ECB's purchasing program for covered bonds and ABS (asset-backed securities). The U.S. investment firm was active during the sub-prime crisis of 2007, when major banks collapsed after loading up on securities backed by mortgages which then defaulted in large volumes.

"We are using Blackrock to help us design our program, which is nothing strange at all," said Draghi. He added that the U.S. Federal Reserve had also hired investment management firms to advise them about QE.

"Their function is purely advisory," said Draghi. "We have been extremely careful about containing any conflict of interest."

'QE coming'

TLTROs and private asset purchases are some of a number of stimulus measures recently announced by Draghi that have left markets wanting more. This has led to a growing number of economists expecting the ECB to launch a Federal Reserve-style quantitative easing (QE) program.

On Monday, Draghi said the bank stood ready to use "further additional unconventional instruments" if necessary. He has stated his willingness to do so repeatedly, fueling hopes of QE.

A team of analysts at Barclays, led by Philippe Gudin, are now so sure the central bank will have to start buying up government bonds that they argue a QE program is the base-case scenario for the euro zone.

"Increasing the ECB's balance sheet by up to 1 trillion euros to its 2012 size is unlikely to be achieved via TLTROs, ABS (asset-backed securities) and covered bond purchases alone," the bank said in a research note on Friday. Barclays believes the new measure will most likely be implemented by the first quarter of 2015.

Read MoreDraghi: ECB to purchase asset-backed securities

"Second, we believe that the risk of too long a period of low inflation is higher than the ECB's inflation projections imply, while the growth outlook has significantly deteriorated and remains subject mainly to downside risks, especially for France and Italy," the bank added.

Draghi reiterated on Monday that inflation would remain low for the rest of the year, before gradually increasing in 2015 and 2016.

Euro zone inflation remained worryingly low at 0.4 percent in August, amid growing fears that the region could be heading towards a period of deflation - where consumer prices start falling instead of rising. The ECB now forecasts inflation will come in at 0.6 percent this year and will not start accelerating until 2015. Barclays believes it will average 0.5 percent this year and 0.8 percent next year.

An economic indicator called the "five-year, five-year forward breakeven rate" plunged close to 2010-lows on Monday. This is used to gauge where markets think euro zone inflation will be at in the future, and is so closely watched that Draghi name-checked it ahead of cutting interest rates earlier this month.

Monday's reading of around 1.91 percent marks a fall below the level it reached in August, when the ECB was forced into action.

Yields spike?

Injecting liquidity into the economy by buying sovereign bonds would be a controversial move by the ECB, and is thought by many to be beyond the ECB's mandate.

Draghi has, for instance, conceded that the euro zone doesn't have the same capital markets as the U.S. does. It will also be difficult to gauge which sovereign bonds should be bought by the central bank, with concerns emanating from Germany that it could dangerously stoke inflation in the euro zone's stronger nations.

Read MoreLagarde: Confident G-20 will reach growth target

"Sovereign debt QE is coming next," Claus Vistesen, the chief euro zone economist at Pantheon Macroeconomics said in a note on Monday morning. Vistesen believes the catalyst for QE would be higher bond yields in peripheral Europe, rather than fears over prolonged low inflation.

This would arise, Vistesen said, if the periphery—which includes countries like Greece, Portugal and Italy—are "allowed" by the European Union and Germany to run larger fiscal deficits next year.

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