The ECB delivered the “big bang” which I had auspicated after last month’s meeting: it cut the Refi rate by a further 25bp to 1.0%, lengthened the maturity of its refinancing operations to twelve months, and announced the launch of direct purchases of covered bonds. The ECB has not ruled out extending purchases to other assets; similarly, it did not rule out further rate cuts, although it signaled that the present level is seen as appropriate in the current circumstances. Behind this lies a cautious assessment of the “green shoots”—the ECB is well aware of the fragility of the recovery. An equally important part of today’s announcement, in my view, is the ECB explicit and firm commitment to unwind its extraordinary measures and drain liquidity in a timely manner once the recovery becomes entrenched. The message is clear: the ECB remains at the forefront in the fight against the recession and the risk of deflation, ready to do all it takes to foster a recovery, but equally ready to reverse course as soon as the growth outlook improves. This is exactly the right approach, and should improve the efficacy of the current policy efforts while bolstering the ECB’s credibility as a guarantor of price stability. The ECB is not lowering its guard. In terms of market impact, the ECB’s insistence that it is not engaging in Quantitative Easing might well negate any weakening impact on the EUR, and with the current more upbeat mood in the market the single currency will remain well supported. Similarly, note that the direct asset purchases might well put some upward pressure on the long end of the curve, both because the ECB will buy private rather than public assets, and because the purchases might be sterilized, which might potentially imply some selling of government bonds. Trichet did not make clear whether purchases of covered bonds would be sterilized or not, the only opaque part of the announcement, which suggests there might still be disagreement on the issue.
The crucial question today was whether or not the ECB would take the plunge and announce direct purchases of financial assets. It did. Trichet had raised expectations for today’s press conference when he stated one month ago that the ECB would today 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 today beyond lengthening the maturity of refinancing operations.
The ECB has decided in principle to buy up to EUR60bn 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 US.
However, the ECB has clearly recognized that the fragility of the growth outlook warrants additional measures. Some members of the GC appeared to be very reluctant to move to direct purchases, so for the GC 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 today’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 played 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 pre-determined 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 it clear that the ECB is taking the green shoots with a big pinch of salt. He noted that hard data were looking somewhat better, but 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 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, that is beyond the base effect on energy prices, and noted that going forward 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 in line with our forecasts, and I would reiterate that the risk of deflation, while small, should in my view 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 today’s 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 keep rates at or below current levels for a prolonged period.
