Today’s decision to leave all official rates unchanged was widely expecte

• No major new action promised today.
• Instead, ECB offers ‘guidance’ on new policy initiative.
• Details yet to be finalised but will only be available to countries in EFSF/ESM Programmes.
• Further ECB rate cut becoming more likely as economic outlook remains gloomy.
• EU policymakers overpromise and underdeliver once again?
• Risks of significant market turmoil increase.

As economic conditions haven’t changed markedly in the four weeks since the ECB cut its key policy rates to historically low levels, today’s decision to leave all official rates unchanged was widely expected.  However, in the light of comments made by Mr Draghi a week ago when he promised to do ‘whatever it takes to preserve the Euro’ markets awaited today’s ECB press conference with a heightened sense of expectation.  The ‘Big Bazooka’ that many in the markets expected today wasn’t deployed.  Instead, Mr Draghi suggested it is not yet fully designed and even when it is designed, it will only be deployed in fairly limited circumstances.  As a result, there is a significant risk that markets judge that the policy response at EU level continues to be far too little and far too late.  This implies the potential for a wicked August in financial markets.

As economic conditions haven’t changed markedly in the four weeks since the ECB cut its key policy rates to historically low levels, today’s decision to leave all official rates unchanged was widely expected.  However, in the light of comments made by Mr Draghi a week ago when he promised to do ‘whatever it takes to preserve the Euro’ markets awaited today’s ECB press conference with a heightened sense of expectation.  The ‘Big Bazooka’ that many in the markets expected today wasn’t deployed.  Instead, Mr Draghi suggested it is not yet fully designed and even when it is designed, it will only be deployed in fairly limited circumstances.  As a result, there is a significant risk that markets judge that the policy response at EU level continues to be far too little and far too late.  This implies the potential for a wicked August in financial markets.
 

Today’s ECB press conference devoted little time to the current economic environment.  It is clear that the growth outlook remains weak and while the ECB expects ‘the Euro area to recover only very gradually,’ it sees the risks to even this gloomy outlook remaining to the downside.  In these circumstances, a further ECB rate cut remains a strong possibility.  When asked whether a rate cut was discussed today, Mr Draghi replied that it had been but the ECB Governing Council had decided that ‘this was not the time’.  New ECB economic projections to be prepared for the early September Policy Meeting could provide a justification for a cut as soon as next month.

Today’s Governing Council Meeting was all about continuing problems on financial markets.  In the opening paragraph of today’s press statement the ECB noted that ‘a further intensification of financial market tensions has the potential to affect the balance of risks to both growth and inflation to the downside’.  Although there was relatively little discussion of inflation today, it remains essential to link these sort of risks back to the ECB’s primary mandate of price stability given major concerns in this regard particularly in Germany.  Having highlighted these risks and their potential implications, the bulk of today’s press statement and the subsequent monthly press conference were taken up with a discussion of how the ECB might put in place an appropriate policy response and what form this might take.

On several occasions today, Mr Draghi suggested that what the ECB was announcing today amounted to ‘guidance’ as to how it would put in place policies in response to the ‘fragmentation’ of Euro area financial markets and related excessive risk premia.  In circumstances where many in the market thought the ECB would roll out major new policies today, Mr Draghi's indication that ‘over coming weeks’ a number of the relevant internal committees within the ECB, including its Monetary Committee, Markets Committee and Risk Committee, would work on the details of this programme and put proposals before the Governing Council for a formal decision fell some significant distance short of expecations.  As work to 'design the appropriate modalities for such policy measures’ is only set to take place in the coming month, we remain some distance from the point where the precise form these policy instruments might take is known.

Of much greater significance, any new policy initiatives will only be activated in fairly narrowly defined circumstances.  First of all, ECB action will only be contemplated where the relevant country is taking part in (or applying for) EFSF/ESM programmes ‘with strict and effective conditionality in line with the established guidelines’.  As Spain or Italy are very reluctant to take part in full programmes (notwithstanding assistance now being provided to the Spanish banking system) this requirement undermines the relevence of today's proposals to current tensions in financial markets.  Moreover, while Mr Draghi added that participation in an EFSF/ESM Programme would be necessary even this might not guarantee ECB action.  The ECB will retain significant discretion and ‘may undertake outright open purchases of a size adequate to reach its objective’ depending on its judgement of the particular circumstances.

Mr Draghi emphasised that the new bond purchase programme would be very different from the controversial and unsuccessful Securities Market Programme that was introduced in May 2010 but has been dormant for much of the intervening period.  He said it would operate 'squarely in line with the ECBs primary mandate' and concentrate on the shorter end of the yield curve that is more relevant for monetary policy purposes.  He also said that the question of ECB seniority to other bondholders would be addressed as part of the design of the programme but he refused to be drawn on the details as to how this might be tackled.

Mr Draghi briefly dealt with a number of other issues related to the monetary policy outlook.  He admitted that moving to a negative deposit rate would take the ECB into ‘uncharted waters’, an answer that might suggest a reluctance to countenance such a move.  He also discussed the prospect of providing the ESM with a banking licence and cited ECB legal opinion that the ESM was not an appropriate counterparty.  With possible options such as these seemingly ruled out, this puts a far greater importance on the bond programme mooted today.  Unfortunately, markets are likely to feel distinctly underwhelmed by the measures outlined by Mr Draghi today.

Today’s ECB Council Meeting seems to be yet another example where EU policymakers appear to overpromise and underdeliver.  Notwithstanding a range of legal, technical and philosophical obstacles, there was a widespread sense that the ECB would announce a dramatic policy initiative for immediate implementation encouraged by Mr Draghi's remarks of last week.  It is certainly possible that the bond purchase scheme whose broad contours were described by Mr Draghi today could in time become a significant policy instrument.  However, we remain unclear about exactly how or when it will be activated and how large it might be beyond an assertion that it will be ‘adequate to reach its objective’.  We also remain unsure as to what precisely its objective might be.  It is difficult to know how far the ECB will be prepared to drive down sovereign spreads and exactly how effective this will be in reversing the fragmentation of financial markets.  What we do know is that this programme can only become operational when countries enter an EFSF/ESM Programme and even then it will be at the ECB’s discretion.  So, the bond purchase programme will not be preventative in nature.  Indeed, given widespread reservations about the prospective firepower and operational capacity of the ESM, problems in the Eurozone could have reached or even passed a critical point before the ECB is ready and willing to use the new bond programme.