Today’s press conference bore the hallmarks of statesmanship: the ECB decided to lean against the wind of upside growth surprises to cool market enthusiasm, and to remind everyone that we have unfinished business to take care of before reaching full normalization. Set against the positive momentum of recent Eurozone data, the tone of the press conference was noticeably dovish. Trichet emphasized that prudence and caution are of the essence, as the recent recovery relies still too heavily on temporary factors, and that the road ahead will be bumpy, with still high uncertainty and marked volatility in the data. Overall, Trichet sent an unequivocal signal that the ECB is in no hurry to deploy its exit strategy, as it sees a strong risk that the recovery will lose steam before reaching a new sustainable pace—the ECB will once again keep a steady hand. At the same time, however, Trichet emphasized that when the time comes, the exit could be swift. Timing the exit strategy will be the hardest challenge. As the gradual pace of the previous tightening cycle is seen as a key cause of the global credit bubble, both the ECB and the Fed will be under some pressure to tighten more decisively this time around, which will raise the stakes on getting the timing just right. This will in turn raise the stakes in fixed income markets, where rate swings might be equally swift.
In a key passage, Trichet emphasized that it would be “plain wrong” to conclude that we can soon go back to business as usual as we see further signs of economic recovery and financial markets normalization—he stressed there is a lot of work still to do to reinforce the resilience of the global financial system if we want to avoid another big crisis down the line. It was the senior statesman reminding us that we cannot forget the lessons of the crisis just because the panic finally fades away. And indeed, we are exiting this crisis with a significantly higher public debt burden and some painfully exposed vulnerabilities in key areas of the global economy. Trichet’s reminder that we all have unfinished business should be taken to heart.
The ECB left rates on hold and reiterated that the Governing Council is unanimous is seeing current rates as appropriate. Trichet also reaffirmed during the Q&A that the 1.0% level on the refi is not seen as a floor, as the bank does not precommit in any respect. He noted that deflation risks now appear to have been avoided, but that the ECB remains vigilant on that front as well. Asked whether recent stronger activity data changed the baseline scenario for an exit strategy, Trichet stated that nothing had changed from the previous meeting.
The ECB acknowledged the recent upside surprises on activity data with a moderate upgrade in its growth forecasts: the revised staff forecasts now see growth at -4.4% to -3.8% in 2009 (previously -5.1% to - 4.1%) and -0.5% to +0.9% in 2010 (previously -1.0% to +0.4%). Better growth performance would be driven by the recovery in exports, the ongoing policy stimulus including measures to normalize the financial system, and the turnaround in the inventory cycle.
Trichet however emphasized that uncertainty remains unusually high and that the data might be very volatile. He acknowledged that growth could turn positive on a quarter on quarter basis earlier than expected (that is before mid-2010), but that this might then easily reverse. He noted that the mid-point of the revised forecasts indicates marginally positive growth next year, but underscored that the significant width of the range implies this cannot be taken for granted.
The ECB is in no hurry to launch its exit strategy—but when the time comes, the exit could be swift. The ECB’s non-conventional measures are such that they can be unwound very quickly, one more reason why the ECB can afford to wait. This, as Trichet stressed, is a tremendous asset in terms of credibility: markets and individuals have trusted the ECB would keep us out of deflation, and can now trust it to offset inflation pressures promptly when necessary.
Timing the exit strategy will in my view be the hardest challenge, especially if the exit is quick. Today, I fully concur with the ECB that we should take a cautious and skeptical view of the sustainability of the recovery. If the data continue to surprise on the upside in the coming months, as they probably will, skepticism will eventually become harder. And given that the slow and gradual pace of the last tightening cycle is now seen as one of the causes of the global credit bubbles, both the ECB and the Fed will be under some pressures to tighten more decisively this time around—which makes the timing all the more important.
Trichet stressed that temporary factors have played an important role in driving this initial rebound, and noted the need to further repair balance sheets in the financial sector and in other sectors as well, both in the Eurozone and in other economic areas. Indeed, we know that further deleveraging lies ahead in the financial sector, that households especially in the US will need to further increase savings, and that corporates still face a challenging outlook. The impulse of fiscal stimulus, on the other hand, is set to fade in the quarters ahead—the US “cash for clunkers” program and similar measures in Europe have provided a very important boost, which will not be repeated.
The ECB remains especially concerned about the persistent fragility in the financial sector and the attendant risks to credit growth. Trichet noted that broad money and credit growth have continued to decelerate, and stressed the divergence between a slightly positive growth in credit to households and a continued decline in credit to non-financial corporations. The ECB remains worried that the oncoming rise in default rates could force banks to reduce credit further just when credit demand might begin to pick up.
Trichet therefore reiterated in identical terms its call on banks to “be responsible”, and to take further steps to strengthen their capital ratios, availing themselves if needed of the support instruments provided by the governments. The current improvement in macroeconomic indicators could reduce the extent of the rise in non-performing loans, while improving confidence could accelerate the healing process in the financial sector. The ECB, however, is clearly not counting on this yet.
Indeed, the ECB has decided not to apply any spread on the rate for the next 12-month liquidity auction (30 September), and Mr. Trichet repeated that the bank considers this longer-term liquidity provision to be a great success, extremely valuable in creating the necessary conditions for a normalization of market conditions and for sufficient credit growth. Asked about the risk that the 12-month liquidity injection would once again be largely redeposited with the ECB, Trichet argued that it might be simplistic to conclude that the banks depositing funds at the ECB are the same institutions drawing liquidity at the auction. He acknowledged though that the coincidence of the two would confirm that the money market is still far from normal functioning.
