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From Accountingnet.ie Recession
The broad thrust of Mr. Trichet’s remarks today and indeed updated ECB projections is that the worst is over for the Euro zone economy but the path to recovery is still uncertain. So, the ECB is likely to maintain its current very supportive policy setting for a considerable period. To reassure markets in this regard, Mr. Trichet’s indicated that the next tranche of 12 month money that the ECB provides to markets (scheduled for 30th September) will be at 1%, the level of the ECB’s main short term policy rate. There had been some speculation recently that the ECB might provide these funds at a premium to the 1% rate. When the ECB first announced that it would supply twelve month funds at quarterly intervals, it indicated these might attract a premium although the first tranche in June was provided at 1%. In light of the recent improvement in economic conditions and the ‘parking’ of substantial funds by banks with the ECB, it was suggested that providing a further tranche of funds at 1% was unnecessary and might even risk an acceleration in inflation in the future. However, Mr. Trichet emphasised a different view. He said that the ECB regards these longer dated operations as a major success. Certainly, the provision of substantial amounts of cheap term money has succeeded in reducing market interest rates paid by business and households across the Euro area. Imposing a premium on the funds the ECB makes available later in September might have led to higher market rates for borrowers at a time when economic conditions remain weak. More importantly, the ECB is clearly sensitive to the risk that markets would have interpreted a higher 12 month tender rate at end September as a subtle shift in policy that signaled the possibility of a formal tightening before too long. Clearly, the ECB is alert to the possibility that a premature policy tightening or even the anticipation of such a course of action by markets could derail what is still a tentative and fragile recovery. By indicating that the next twelve month refinancing operation will take place at 1%, the ECB is emphasising that markets shouldn’t expect an early switch from the current focus on supporting economic activity and the financial system. Today’s decision shouldn’t be taken as signaling a commitment that the ECB won’t raise rates before September 2010. However, the willingness to provide long term liquidity at extremely low rates can be seen as underlining that support to the economy remains the priority of the ECB at present. As a result, interest rate increases remain a very distant prospect. The decision to continue to allocate twelve month funds at the prevailing short term policy rate owes a good deal to a view – shared by most policy makers in the major central banks, that while the freefall in economic activity may have ended and signs of a tentative improvement have emerged, the recovery is unlikely to be rapid or extremely strong. Official concerns about the likely speed and scale of the emerging upturn are possibly best captured in the phrase used on several occasions of late by Mr. Trichet and repeated today that a ‘bumpy road’ may lie ahead. This means that the ECB as ‘driver’ of monetary policy should proceed very cautiously and avoid sudden changes in its steering. Effectively, this is what Mr. Trichet signaled today. Further justification for a ‘steady hand’ approach comes in the form of new ECB projections for economic growth and inflation released today. While these show some improvement compared to the previous estimates made in June, the expected drop in GDP in 2009 at 4.1 per cent is still substantial. Of far greater significance, GDP is expected to grow by just 0.2 per cent in 2010. Again this is somewhat better than the 0.3% decline envisaged in June but it is lower than many recent market estimates and just below last months estimate from the ECB’s survey of professional forecasters. In reality, the difference between the marginally negative growth rate predicted in June and today’s marginally positive growth rate is not dramatic and so it is understandable that the ECB should want to strike a cautious note on the recovery. To further underscore this point, today’s press statement also noted that ‘overall, the recovery is expected to be rather uneven, given the temporary nature of some of the supporting factors and the ongoing balance sheet correction in the financial and non-financial sectors of the economy, both inside and outside the euro area’. In short, the ECB is relieved that conditions seem to have improved of late but it is far from relaxed that this improvement will inevitably continue. The subdued outlook for growth means that inflation is seen remaining below the ECB’s target of ‘below but close to 2 per cent’ in 2010. This provides significant leeway to continue with an accommodative policy into next year. However, the ECB also indicated that they continue to ‘expect price stability to be maintained over the medium term’. So, there is no need to countenance additional measures to support activity as the Bank of England had done in early August. The exceptional nature of the current downturn justifies the ECB’s caution. So too does history, as graph 1 indicates. In the late ‘90s and again in 2003/2004, the Euro zone recovery was comparatively late and notably less robust than in the US. There is little to suggest that the Euro zone economy will perform dramatically better in the next year or two. As a result, the ECB has no need to rush to tightening. Indeed, as graph 2 below shows, the ECB might again have the luxury of waiting for tightening to begin elsewhere. As a result we think current market expectations that ECB tightening will begin in the second quarter of next year may be a bit premature. Instead the ECB (and other major central banks) will want to be sure that the recovery is self sustaining. That makes it more likely the ECB won’t begin raising rates until at least the second half of next year.
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