• Easing. At its May meeting, the ECB lowered its key interest rate to 1.0%. As a result, it has probably reached the low point. Instead, additional unconventional measures are being implemented. Full allocation of Refi operations is, as expected, being extended to 12 months. Moreover, the Governing Council agreed to purchase covered bonds (page 2).

  • Uncertainty. The Fed and the BoE are already pursuing direct purchases of securities (page 8). This week, the BoE more than doubled its program to GBP 125 bn. The extremely loose monetary policy combined with the severe global recession, which even deepened further in many countries in the first quarter (page 11), is resulting in widely diverging inflation assessments.

  • Anchored. The central banks rate the inflation picture currently as balanced, underpinned by still firmly anchored medium-term inflation expectations (see chart). High excess capacities around the globe as well as the steep rise in unemployment make a price spiral look highly improbable in the foreseeable future (page 4).

  • Caution. To maintain their credibility with respect to price stability, the central banks must, however, keep their assertion. Once the recovery becomes entrenched, they have to use the measures at their disposal to siphon off the excess liquidity in a timely manner. Otherwise, the case for inflation expectations getting out of control will clearly intensify.

  • Further topics:

    – Data outlook: EMU: GDP contracted strongly in Q1 (page 13).

    – Market outlook: Bonds on the offer side; GBP remains under pressure (page 20).


Big bang

The crucial question this week was whether or not the ECB would take the plunge and announce direct purchases of financial assets. It did. Trichet had raised expectations for the May press conference when he stated one month ago that the ECB would then announce whether or not it was prepared to launch further non-conventional measures. Since then, there had been many indications that the Governing Council’s debate on the need for such measures and on the technical complications involved was still very intense, flagging a risk that no agreement would be reached by May beyond lengthening the maturity of refinancing operations.

The ECB has decided in principle to buy up to EUR 60 bn in covered bonds, beginning in June, to help revive a specific market segment that it sees as particularly affected by the financial crisis. With this targeted action, the ECB aims to further ease financing conditions for both banks and corporates. Moreover, the ECB has not excluded the possibility of expanding the purchase program to other assets - to be precise, Trichet noted that no decision has been taken beyond that regarding covered bonds.

For the ECB this is a big, bold and decisive step. The extraordinary operations adopted so far on the liquidity front have been very effective—as Trichet pointed out, 3-month and 6-month market rates in the eurozone are now lower than in some countries where policy rates are at zero, and Euribor/OIS spreads are lower in the eurozone than in the UK or the US. However, the ECB has clearly recognized that the fragility of the growth outlook warrants additional measures. Some members of the Governing Council appeared to be very reluctant to move to direct purchases, so for the Council as a whole this is indeed a big step.

Targeting private assets allows the ECB to steer clear of accusations that it would be monetizing fiscal deficits. Of course, it cannot avoid the criticism that the measure will help some countries more than others, and already in this week’s Q&A Trichet was asked whether buying covered bonds would not favor German banks. In fact, in a recent paper, the ECB noted that covered bonds issued from Denmark, Germany, Spain, France and the UK accounted for 84% of the total outstanding at end-2007. Germany and to a lesser extent Denmark account for the lion’s share. Trichet naturally countered that all decisions were taken in the best interest of the eurozone as a whole, but more importantly, we need to bear in mind that given the fragmented nature of eurozone markets, no instrument could have been seen as “fair”. And while the immediate impact might be stronger in some countries, this measure will bring important relief to the whole area by easing overall credit conditions.

Trichet signaled that the refi rate is likely to remain at 1.0% for a while, but made it clear that this was not a predetermined floor. In other words, the ECB considers the current level of rates as appropriate given current conditions, but does not exclude further cuts should circumstances change.

Trichet also made clear that the ECB is taking the green shoots with a big pinch of salt. He noted that hard data were looking somewhat better, however following a much weaker than expected Q1, which would leave its mark on the rest of the year. In other words, economic activity seems to be stabilizing but at a very low level. He warned that the ECB staff forecast would be revised downwards further, and that the economy faced a deep recession this year and a tentative recovery next year.

Similarly, Trichet acknowledged a broader cooling off of inflation, which is beyond the base effect on energy prices, and noted that going further inflation would continue to be dampened by weak levels of activity. This is in line with our assessment that core inflation will continue to decline in response to the widening output gap. Trichet noted that inflation will be negative “for some months”. This is also in line with our forecasts, and I would reiterate that the risk of deflation, while small, should not be underestimated.

Trichet also noted that current arguments that central banks’ policies are laying the ground for a resurgence of inflation are both unjustified and extremely counterproductive - something on which I strongly agree.

The ECB announced that the maturity of refinancing operations will be lengthened to twelve months, and that starting in July the European Investment Bank will become an eligible counterparty.

An equally important element of the May press conference, in my view, was the ECB’s clear and firm commitment to promptly unwind its extraordinary operations and drain liquidity once the recovery becomes entrenched. This strikes exactly the right balance: a decisive commitment to do all that is necessary to fight the recession and the risk of deflation, accompanied by an equally decisive commitment to reverse course as soon as needed. This should maximize the efficacy of the current policy effort, while ensuring that longer term inflation expectations remain firmly anchored. In this regard, Trichet did well not to commit to keeping rates at or below current levels for a prolonged period of time.