Mr. Trichet today confirmed that the ECB will keep outstanding liquidity ample for the time being while shortening its duration, to be able to withdraw it in a prompt and flexible way. The steps outlined today were in line with what we advocated, and I still believe we will see short term market rates remain low through the summer and then rise gradually back in line with the Refi, opening the way for a first rate hike in Q1 2011. The ECB gave a ringing endorsement to Greece’s latest efforts and subscribed unconditionally to the idea of an expansionary fiscal contraction—in stark contrast with the IMF’s new philosophy. Mr. Trichet also cast the handling of the Greek crisis so far as demonstration of the successful functioning of the eurozone, which I believe is going quite a bit too far. The jury is still out, and the eurozone is not out of the woods yet, it still needs to demonstrate that it can enforce fiscal discipline while generating stronger and sustainable growth. Mr. Trichet also demolished IMF Chief Economist Blanchard’s suggestion of a higher inflation target, and warned that IMF lending would not be “appropriate” for a eurozone member.
The much-awaited roadmap for the exit strategy was almost perfectly in line with our recommendations and predictions: (1) the last 6-month Long-Term Refinancing Operation (scheduled for 31 March) will be held at a variable rate equal to the average minimum bid rate at the Main Refinancing Operations over the relevant 6 months, as was done for the last 12-month LTRO; (2) the regular 3-month LTROs will go back to a variable rate system starting on 28 April; (3) the regular weekly MROs and the special 1-month operations will remain at full allotment, fixed rate at least until 12 October 2010.
The driving principle of the exit strategy at this stage therefore remains to shorten the duration of outstanding liquidity, so as to be able to drain it in a more timely and flexible manner when appropriate. The message is extremely clear: the ECB will continue to provide ample liquidity for as long as necessary, and is only accompanying the gradual normalization process in financial markets, not forcing it; at the same time, as the normalization is indeed under way, some of the exceptional support measures are no longer necessary, and the ECB is preparing to withdraw liquidity as needed.
I see today’s decisions as consistent with our call of a first refi rate hike in Q1 2011, and the most likely outlook is that short-term market rates will remain low through September to then rise fairly rapidly back in line with the 1.0% Refi, opening the way for the first hike: the introductory statement specified that allotment at the 3-month operations will be set to ensure smooth conditions in the money markets and to avoid “significant spreads” with the prevailing MRO bid rates; moreover, in the Q&A Mr. Trichet indicated he does not expect EONIA rates to rise in the short term (they remain currently at about 0.35%), and declined to comment on current market expectations that the first rate hike will only occur in August- September next year—Trichet only stated “the market knows we will take whatever decision is needed to ensure price stability”. He also emphasized, as in previous press conferences, that the decisions taken “with overwhelming consensus” on the liquidity operations should in no way be seen as signals of possible changes in the monetary policy stance, which is still seen as appropriate by the unanimity of the Governing Council.
