Flash Comment: ECB Unlikely To Be Radical But May Keep Rates Lower For Longer

ECB Unlikely To Be Radical But May Keep Rates Lower For Longer

• Trichet says little new about ECB purchases of Government bonds.
• Are serious internal divisions within the Governing Council preventing radical action?
• A compromise solution may be that interest rates remain lower for longer and money market liquidity more ample.
• New ECB projections see 2011 economic growth prospects revised downwards.
• Inflation also seen remaining subdued because 'domestic costs to remain low'.
• So, economic rationale for low interest rates is strengthened.
• As a result, ECB sees no problem with weaker FX value of Euro.…

In normal circumstances today's ECB press conference might have been a non-event. There is little expectation that the ECB will raise its key policy rates for some considerable time. Indeed, current market expectations don't envisage the start of the tightening cycle will be seen until early 2012. But these are not normal circumstances and the difficulties Jean Claude Trichet, the ECB President, faced today are at least partly of his own making. A month ago at the May press conference, Mr Trichet created the impression that the ECB seriously underestimated the breadth and intensity of problems in European bond markets and renewed difficulties in the money market. This proved the catalyst for a sharp sell off in equity markets, the virtual closedown of several Eurozone bond markets and heightened tensions in money markets.

Is the ECB divided?

The deterioration in financial market conditions that followed last month's press conference prompted the creation of the European Financial Stability Facility and also forced the ECB into a radical departure; the purchase of Eurozone government bonds. However, markets continue to have serious reservations about both the capability and willingness of European policymakers to take sufficient and early action to restore the European financial system to anything that might be described as normal functioning. Unfortunately Mr. Trichet did little today to eliminate such doubts. He provided nothing by way of new information on the rationale for the bond purchase scheme or on its likely future scope. As a result, he did little to downplay market perceptions of serious divisions within the ECB council in regard to the appropriateness of the current government bond purchase programme. This will fuel the view that the ECB has moved into an area in which it is rather uncomfortable. Accordingly, it is unlikely to act in a particularly forceful manner. Again, it is important to emphasise how market sentiment can be affected by perceptions that the ECB is unsure and indecisive at present. As a result, as the diagram across shows, bond markets remains dysfunctional and the Euro remains under pressure.

If the ECB hinted that its foray into bond markets would remain limited, it pushed back its exit from support to the money market by announcing new 3 month refinancing tenders offering unlimited funding at 1% at the end of August and September. The most important aspect of this announcement is likely to be the signal it sends rather than the technical provision of additional liquidity. There is a clear commitment to provide money market support as long as this may prove necessary.

In this respect, today's announcement strikes a very different note to recent comments by ECB Chief Economist Jürgen Stark who suggested that the maturity of some €442 bio of 12 month ECB funding on July 1 would provide an opportunity to tighten liquidity conditions in the months ahead. Clearly, the ECB recognises a need to reassure market participants that easy access to ECB funding will not be reduced anytime soon. While it may be uncomfortable with dramatic interventions in the Government bond market, its commitment to the money market remains unswerving

Weaker growth to keep interest rates lower

While the ECB's new economic projections also released today were not awaited with any great anticipation, they do paint a picture consistent with no increase in ECB rates until the latter stages of 2011 at the earliest. Accordingly, they do little to dent money market expectations that rates might not rise until early 2012. Today's projections entail modest upward revisions to both growth and inflation for 2010. However, a more significant development is that the ECB forecast for growth in 2011 has been revised down to 1.2% from the 1.5% rate envisaged in its March forecasts. So, the ECB don't see a marked pick up in the momentum of Eurozone growth in the coming year. In turn, the expectation of a lacklustre upswing in activity implies that inflation will be subdued. While the ECB raised its forecasts for inflation, the increase for 2011 from 1.5% to 1.6% has to be seen as minimal in the context of a markedly weaker Euro, a likely further increase in inflation towards 2% in the latter months of this year and the probability of a significant contribution from increases in indirect taxes next year. Clearly, the ECB believes subdued activity will depress costs within the Euro area. Indeed, this was explicitly signalled in today's comment that 'domestic price pressures are expected to remain low'. The significance of these remarks lies not only in their implications for the interest rate outlook but also in the important tonal difference from last month's press conference which had hinted at a slight element of emerging concern about inflation.

It could be suggested that the ECB's recognition of the restraining influence of financial tensions on activity coupled with its reluctance to forcefully employ 'shock and awe' tactics to revitalise markets has led the ECB to conclude that the Eurozone economy will remain weaker for longer. Consequently, ECB interest rates will need to remain lower for longer. The step-down in inflation risks between the May and June press conferences reflects in part a weaker outlook but it may also indicate a desire to signal that ECB tightening should not be envisaged for the foreseeable future. It might also be speculated that this marks something of a compromise between different views on the ECB Governing Council. If Germanic influences mean there are reservations about the scale of Government bond purchases that can be contemplated, there may need to be an offsetting delay in any form of tightening or liquidity withdrawal from the money market.

The weaker Euro isn't hurting and may be helping

Finally and significantly, Mr Trichet made it clear that the ECB is not concerned with the recent weakening of the Euro. Mr Trichet deflected a couple of questions today on the Euro's FX weakness (or external purchasing power) by answering that its internal purchasing power as measured by price stability has been preserved. So, Mr. Trichet is suggesting that the current FX value of the Euro is relevant in terms of its impact on Eurozone inflation rather than its value against other currencies. With inflation weak and domestic demand in the Eurozone likely to be sluggish at best, the strong, if implicit, message from Mr Trichet is that the current value of the Euro is to be welcomed rather than worried about. In this respect there is a consistency with the message on interest rates. The Eurozone economy can do with a little help to compensate for the impact of weak domestic activity, tighter fiscal policy and strains in some parts of the financial markets. While the ECB is reluctant to come up with radical responses to those problems, it seems to view low official rates and a supportive exchange rate as elements of the solution.