While it was universally expected that the European Central Bank would leave its key policy rates unchanged today, there was quite an amount of interest in the monthly press conference which followed the rate announcement. In recent weeks we have seen a number of Central Banks, most notably the Reserve Bank of
Australia and the Norges Bank start to raise interest rates. In contrast, the US Federal Reserve Bank last night repeated its commitment to keep “exceptionally low levels of the federal funds rate for an extended period” while earlier today the Bank of England stepped up its support for the economy by boosting the amount of quantitative easing by a further£25 bo.
So, after a year or more in which virtually all the worlds Central Banks were united in aggressive efforts to support economic activity and sustain the financial system, some significant differences are beginning to emerge as to what policy action is now required. Although Mr Trichet’s comments today continued to give the ECB room for manoeuvre, there is little doubt that he signalled a clear intention to begin scaling back the exceptional liquidity support the ECB is providing to the Euro Zone banking system. For a wide variety of reasons , the threat of any increase in ECB rates is still very distant but markets are likely to begin to debate when tightening will commence
Compared to it’s October press statement, the European Central Back is now marginally more upbeat about eurozone economic prospects. A month ago, the ECB talked about “a stabilisation of activity”. Today, it talks about an improvement in the second half of this year. The ECB also sees recovery continuing “at a gradual pace” in 2010, whereas in October, it merely talked about “a rather uneven” improvement. It should be emphasised that the ECB continues to caution that the outlook for activity “remains subject to high uncertainty”. Importantly, the ECB sees no significant risk of a surge in inflation. Once again, it sees “over the policy relevant horizon, price and costs developments staying subdued, reflecting ongoing sluggish demand in the Eurozone”.
So, there is nothing in the ECB’s assessment that hints at any need for an urgent policy shift. This suggests to us that interest rates increases remain a relatively distant prospect and shouldn’t become a serious possibility until well into the second half of next year. However, the real significance of today’s ECB comments is that the ECB is signalling its intent to withdraw some of the exceptional support it has provided to the banking system a good deal sooner.
Mr Trichet strongly hinted that the ECB will not offer any further special 12 month refinancing operations after the one scheduled for December 16th next. Mr Trichet said that “not all our liquidity measures will be needed to the same extent as in the past” and he also stated that he wouldn’t want to alter what he felt was the market view that the 12 month refinancing in December would be the last of this type of operation. Through these sort of comments, Mr Trichet is trying to emphasise that these actions shouldn’t be seen as the start of a tightening process. Rather, they are a natural response to an easing in financial market tensions and an associated drop in demand for liquidity from the ECB.
Although Mr Trichet clearly signalled the ECB’s intentions he was reluctant to provide much detail today but instead spoke of an important “rendez vous” at the ECB’s December Governing Council Meeting. While that meeting will formally announce the intention not to offer any further 12 month refinancings after the December operation,and may also hint at a winding down of other term funding.It should also indicate whether the ECB intends to charge a premium above its refinancing rate for those funds in December, we are unlikely to get a great deal more information next month.
We certainly don’t expect to be given any sort of outline of the ECB’s intention for 2010 for a range of reasons.
First of all, as the ECB reiterated today, the outlook is extremely uncertain. In addition, as Mr Trichet regularly reminds us, the ECB never pre-commits.Finally, and more practically, the ECB doesn’t really need to plan major changes as the rest of the ECB’s crisis support measures for the banking system will end of their own accord during 2010 unless they are renewed
Although the European Central Bank may seek to portray the ending of the 12 month refinancing operation and the likelihood of a winding down of other term funding in early 2010 as a “natural” occurrence that reflects an easing in financial market tensions, the process may be a good deal more complicated for a couple of reasons. First of all as the diagram across indicates, relatively little of the support now provided by the European Central Bank to the Eurozone financial system now goes through the main weekly new refinancing operation. While withdrawing the longer dated operations will be a slow process and will take us through to the end of 2010, the impact is potentially dramatic.
A Second Complicating factor is the link between liquidity support to the financial system and the stance of monetary policy. Since the money market crisis began in August 2007, the ECB repeatedly tried to emphasise the difference between its support for the banking system and its interest rate policy. This was underlined by its judged interest rate increase implemented in July 2008. However, it wasn’t until liquidity support and interest rate policy were both pointed aggressively in the same direction that they began to have some effect. Markets may begin to wonder how easy and affective it will prove to remove liquidity support while keeping policy rates at extremely low levels. So, consideration may turn to the possibility of ECB rate increases by the middle of next year
We think the process of progressively reducing liquidity support will be quite a delicate operation and in itself this will limit scope to raise policy rates for some considerable time. More fundamentally, the fragility of the economic outlook and subdued inflation prospects reflected in the words of the Federal Reserve and the deeds of the Bank of England in the past twenty four hours Suggest that the ECB is unlikely to see a strong case for raising rates anytime in the first half of 2010. Indeed, the stance of other Central Banks holds out the risk of a surge in the value of the Euro on FX markets if the ECB were to move quickly to a tightening stance. As a result, we still feel September of next year is the earliest date likely for the start of the ECB rate raising cycle.
