The ECB didn’t change its key interest rates

• ECB a little more worried about economic activity, a little less concerned about inflation.
• Draghi indicates ECB examining its monetary stance ‘extensively’.
• Balance between 'hawkish' and 'dovish' views on Governing Council may be changing.
• Markets may focus on possibility of further ECB easing.
• Significant obstacles to additional ECB action but strength or weakness of data will decide.

The fact that the European Central Bank didn’t change its key interest rates or announce any new policy initiatives today came as little surprise to financial markets.  Neither were there any dramatic changes in the tone of comments made by ECB President Mario Draghi at the monthly press conference that followed today’s Council meeting of the ECB Governing Council.  A fractional rise in money market interest rates and in the FX value of the Euro suggests some had expected a clear softening of the ECB’s stance to be signalled.  Instead, there were subtle signs that recent weakness in survey data and signs of a continuing deterioration in the jobs market are having some impact on ECB thinking. These poorer numbers prompted Mr Draghi to emphasise the ‘prevailing uncertainty’ in the current environment.  At very least, we remain some considerable distance from any tightening of ECB policy but a more intriguing issue raised by today’s comments is what scale of deterioration in economic conditions might be required to prompt the ECB to consider easing policy further.

In our commentaries on the monthly ECB policy meetings for March and April we suggested there had been a slight hardening of ECB thinking that reflected (1) some increased nervousness about inflation (2) a greater confidence that the Euro area economy was recovering (3) a sense that the ECB had made a dramatic and decisive intervention through its two tranches of three year LTRO’s and (4) an instinctive discomfort with the current accommodative policy setting on the part of a number of the more hawkish members of the Governing Council.

A number of subtle changes to today’s ECB press statement suggests the ECB recognises increased risks to the downside for Euro area activity and that those of a more dovish disposition have gained a greater measure of influence.  The first paragraph reflects the significant weakness seen in a number of survey indicators for April by highlighting the ‘prevailing uncertainty’ in the current environment although the statement goes on to say that ‘economic activity is expected to recover gradually over the course of the year’.  In response to a question, Mr Draghi noted that recent indicators weren’t enough to change the ECB’s expectations for a gradual recovery but he added that the outlook would probably be clearer next month when new ECB forecasts are presented.

We feel that ECB thinking may also be influenced by revised expectations of the negative impact of austerity measures on economic growth.  In an unusual discussion of fiscal consolidation towards the end of today’s press statement, the ECB acknowledged that ‘the necessary We feel that ECB thinking may also be influenced by revised expectations of the negative impact of austerity measures on economic growth.  In an unusual discussion of fiscal consolidation towards the end of today’s press statement, the ECB acknowledged that ‘the necessary.

What we would regard as a relatively modest step-up in ECB concerns about the prospects for activity in the near term was accompanied by a fairly limited toning-down of concerns about inflation.  Last month’s press statement had highlighted ‘upside risks in the near term’ – a worry which no longer features in today’s comment.  This change is unlikely to stem from the marginal drop in inflation to 2.6% reported for April from the 2.7% rate that had prevailed for the previous four months.  However, recent survey data point to some easing in price pressures that could be expected to be amplified further by a softer trajectory in activity.  At a general level, it would seem that inflation concerns are no longer quite as prominent because of the emergence of potentially more threatening uncertainty about the health of the Eurozone economy.  Conspiracy theorists would probably add that a significant and timely toning down of inflation concerns would also be a necessary precondition for any potential discussion of a further policy easing in the months ahead.

Probably the most intriguing element of today’s press conference was Mr Draghi’s acknowledgement on more than one occasion that the ECB had discussed its current monetary policy stance ‘extensively’.  This is unusual for a number of reasons.  First of all, the ECB rarely describes its policy discussions in this way.  Second, it seems slightly surprising that there would be a particularly detailed policy discussion just ahead of next month’s meeting when the ECB will have a new set of economic projections.  Finally, it would typically be the case that the two ECB meetings per year that are held away from Frankfurt (today’s meeting was in Barcelona) tend to be relatively low key in terms of policy formulation.

For all these reasons, it is somewhat unusual that Mr Draghi referred to a detailed discussion of the monetary stance today.  However, the conclusions that he reported had come from these discussions were very limited.  He indicated that these discussions found that (1) the current policy stance is accommodative, (2) that liquidity is abundant and (3) that any exit strategy from the current accommodative policy remains premature.  It would be extraordinary if the ECBs examination of its current policy stance didn’t produce notably more insightful findings than these outlined today by Mr Draghi.  We wouldn’t exaggerate the significance of Mr Draghi’s subsequent remarks that the ECB never precommits as pointing towards any near term change in policy but we think that a fairly fundamental examination of the stance of ECB policy has been taking place.  This probably reflects significant disappointment at signs of renewed weakness in the Euro area economy of late.  It also likely owes something to increased calls for the ECB to undertake further supportive policy action by the IMF and OECD as well as the strong likelihood of increased pressure on the ECB at a political level in recent weeks.

In circumstances such as these, a sequence of weaker than expected data in the coming month could translate quickly into a heightened focus on the possibility of a further ECB easing.  It should be recognised that the obstacles to additional ECB action are formidable.  First of all, it will take some time to establish whether the poorer trend in surveys of late reflects a temporary soft spot or something altogether more significant and sinister.  Given the unsteady trajectory of activity in the Eurozone (and across most other ‘Western’ economies) in the past year or so, it would be reasonable for the ECB to wait for a couple of months confirmation before arriving at a definitive judgement.  A second consideration for the ECB is that a number of influential council members may feel the scope for further action is severely limited by the coincidence of an already accommodative policy and an uncomfortably high inflation reading at present.  Some guidance in relation to this possibly vexed issue may emerge from next month’s ECB staff projections.  Finally, it could be asked what more the ECB can do.  Certainly, the benefits of a further cut in short term rates may be considered limited by some and there appears to be a strong reluctance to step up Government bond purchases through the Securities Market Programme for a variety of reasons.  Although a further LTRO has not been ruled out, concerns about collateral quality have been expressed by a number of ECB officials.  That said, when asked today about the possibility of a further LTRO Mr Draghi pointedly responded that ‘we never pre-commit’.  He then went on to list a range of ways in which the benefits of the previous LTRO’s were now being felt.

What circumstances might cause the ECB to act and what actions it might take are questions that are likely to attract a good deal more attention in the next couple of weeks.  The tone of Mr Draghi’s comments today hint that such discussions have intensified within the ECB of late.  It will likely take significant evidence of a marked deterioration in economic circumstances to prompt a further ECB easing but such a possibility could become a key focus for markets in the weeks ahead.

The door to a further easing is no longer completely shut but it may take a marked worsening in economic conditions to prompt the ECB to cut rates again or contemplate even more extreme actions.  It certainly seems the case that the June policy meeting will announce that full allotment at all the ECBs refinancing operations will be extended for at very least another three months and more likely into early 2013. That would probably be regarded by the hawks as approaching a further easing. However, weak data will make the markets look for something more substantial.