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Friday Notes

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ECB in comfortable position

Fri, Jun 5 2009, 11:23 GMT
by UniCredit Research

UniCredit Group

• Floor. The ECB held its key interest rate unchanged at a record-low 1.0% at the June meeting. This underscores that the floor – as already previously at other large central banks – has, therefore, probably been reached. In the current (economic) environment, the short-term interest rate level is considered appropriate (page 2).

• Purchase. The direct purchase of EUR 60 bn in covered bonds, already announced in the previous month, will get under way in July. The central bank is hoping for automatic sterilization of the additional liquidity via lower use of refi transactions – as has already been observed since February.

• Exit. The ECB balance sheet has, therefore, been "shortened" again considerably, in contrast to the Fed, where extended bond purchases continue to inflate the monetary base (cf. chart). At this point in time, the ECB has no plans for further purchases – full stop. If this were to remain the case, it is, relatively speaking, in a comfortable situation with respect to a timely exit strategy.

• Anchored. Accordingly, President Trichet sees inflation expectations still firmly anchored. Even though the traded break-even inflation rate has risen significantly since the end of last year, the increase so far corresponds primarily to the pricing out of a deflation scenario. Although the inflationary pressure will likely continue to moderate appreciably in the foreseeable future, a longer-term, broad-based pullback in consumer prices remains improbable (page 4).

• Further topics:

  – US: Decline in the trade balance coming to an end (page 7).
  

  – Data outlook: EMU: Industrial recession slows down; US: Retail sales to improve modestly (page 9).
  

  – Market outlook: Room for further steepening; EUR-USD in calmer waters (page 17).
  

Appropriate, but...

The ECB kept the refi rate on hold at 1.0% and confirmed that it regards this level as appropriate given the policy decisions adopted so far (including the covered bonds purchase program) and the macroeconomic outlook. At the same time, the door is left open to possible further monetary or credit easing if and when warranted – in particular, the 1.0% refi rate level should not be seen as a pre-decided floor. ECB President Trichet was equally clear in stressing that there is at this stage no decision or bias on whether the asset purchase program could be expanded in size or scope.

The ECB also maintained its cautious assessment of the signs of stabilization and recovery: according to the revised staff projections, the recession will continue for the remainder of 2009, albeit at a significantly slower pace than in the last two quarters; positive growth will only return in Q2 next year, and average growth for 2010 is now expected to be negative (compared to flat in the March projections—this was the only surprise of the meeting). Inflation forecasts are for a midpoint of 0.3% this year (down from 0.4%) and 1.0% next year (in a 0.6-1.4% range, unchanged).

The main message therefore is that the ECB is willing to accept a slow and moderate recovery with inflation below target rather than running the risk of delivering excessive additional stimulus. The ECB staff forecast of inflation at 1.0% in 2010 would seem to contradict the bank’s assertion that the current policy stance is consistent with price stability over the policy-relevant horizon, if we take this to be 18-24 months. Moreover, while the ECB’s statement repeated that inflation expectations remain well anchored, in recent months consumer inflation expectations have dropped to historical lows, and are likely to decline further as inflation turns negative during the summer. Both points were raised in the Q&A session, and Mr. Trichet deflected the implicit criticism by noting that the ECB’s preferred gauges of inflation expectations, including the survey of professional forecasters and 5Y5Y forwards, are still in line with the ECB’s definition of price stability.

While the staff’s latest inflation forecasts would seem to call for further easing, the ECB’s cautious stance is understandable: the economy appears to be bottoming out and equity markets have been signaling rising optimism; inflation will return on an upward trend after the summer; there is still an unusually high degree of uncertainty on the outlook, and a large amount of policy stimulus is in the pipeline. The ECB therefore prefers to keep its powder dry and deliver more easing only if growth weakens again. In other words, the ECB is willing to accept a slow recovery rather than running the risk of an overshooting of inflation in case of a strongerthan- expected growth rebound or of a supply shock to energy prices. The recent signs of economic stabilization support the ECB’s stance, but given the persistent fragility of the growth outlook I would favor additional stimulus now, particularly as with a prolonged recession putting sustained downward pressure on core inflation, downside risks to inflation still predominate.

Those who hoped or asked for an explicit stance on whether bond purchases would be sterilized were once again disappointed. Under pressure, Mr. Trichet said he expected that the purchases would be automatically sterilized – presumably meaning that banks selling the assets would reduce their demand for liquidity at other ECB facilities. He added that if such automatic sterilization did not materialize, the ECB would act to ensure its monetary strategy remains on track. This rather vague formulation suggests that the ECB would prefer the purchases to be sterilized, and currently believes the system does not need additional liquidity. This is in line with last month’s assertion that the objective is to improve conditions in a specific market rather then loosen overall monetary conditions. However, the statement falls short of committing to full sterilization. This suggests that the Governing Council has not yet agreed on what to do if the liquidity injected through asset purchases is not offset by reduced demand at the refinancing operations – which in principle leaves open the possibility that the ECB will only partially sterilize the purchases if it comes to the conclusion that the financial system does in fact need additional liquidity.

The key implementation details of the covered bonds purchase program are: 1) Purchases will be carried out in both primary and secondary markets with banks participating in the ECB refinancing scheme; 2) The ECB will regard as eligible instruments already accepted as collateral. Bonds must have as a rule a volume of about EUR 500 mn or more and in any case not lower than EUR 100 mn. Moreover, they must have as a rule a minimum rating of AA by at least one of the major rating agencies, and in any case not lower than BBB/Baa3; 3) The purchase program will start in July 2009 and will be fully implemented by June 2010. As we have already flagged recently, the ECB will concentrate on 3-10Y maturities, given that this is the most relevant bucket of the lending curve.

Asked to comment on the euro’s recent strengthening, Mr. Trichet noted “with solemnity” the recent statement by the US Treasury and Fed that a strong USD is in the US’s interest. My reading remains that the ECB on balance does not mind a moderate strengthening of the euro at a time when energy price pressures are re-emerging, but is of course wary of the risk that the appreciation might accelerate in an uncontrolled fashion. Together with the ECB’s reluctance to ease policy further at this stage, this remains consistent with my expectation of further EUR-USD upside.

The ECB called on eurozone banks to strengthen their capital positions, taking advantage of government-sponsored facilities when appropriate. This shows the ECB is still well aware that the financial system is not out of the woods yet. The fact that stress tests are still carried out on a country by country basis, neither comparable nor publicly disclosed, is very sub-optimal in this respect, hindering a more rapid return of confidence. The ECB, however, was obviously not in a position to criticize the existing institutional set-up of supervisory responsibility, and therefore simply urged national authorities to proceed with the tests.

The ECB’s statement argued that the crisis should be used as an opportunity to accelerate structural reforms, including on labor and product markets. The ECB’s strong position on this is commendable, particularly as other European policymakers have gone as far as praising some structural rigidities as providing a cushion against the recession. In fact, to the extent that rigid labor markets slow down the increase in unemployment, they are simply shifting the cost of unemployment insurance from the government to private firms, which will make companies even more reluctant to hire again in a recovery. Europe desperately needs to boost its longer term growth rate, including to facilitate the process of fiscal consolidation, and structural reforms should therefore indeed be accelerated.

Mr. Trichet was of course asked to comment on Mrs. Merkel’s surprising criticism. He said he had had a conference call with Mrs. Merkel, where she assured him that she is defending the bank’s independence. This can be seen either as Orwellian diplomacy, or as an assurance that she needed to make those statements for the benefit of her political campaign, but that she did not really mean them. Either way, as Mr. Trichet said, the ECB has repeatedly demonstrated its ability to ignore political pressure.

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Published on  Fri, Jun 5 2009, 11:50 GMT