Mr Draghi’s press conference lived down to expectations

 No major policy signals from ECB

• Interest rates to remain on hold unless poorer activity forces rate cut

• No significant new information on ECB’s new bond buying scheme

• We still think that Outright Monetary Transactions (OMTs) may be less widely and less forcefully used than markets seem to expect

• Differential treatment of Portugal and Ireland make little sense but may hint at a reluctance to move too soon.

In marked contrast to the past three our four months, there was little anticipation of fireworks at today’s ECB policy meeting and, by and large, Mr Draghi’s press conference lived down to these fairly limited expectations. While the economic situation in the Eurozone remains weak, the ECB view is that its July rate cut and the calming effect on financial markets of last month’s announcement of Outright Monetary Transactions (OMTs) should act to support activity and ward off the risk of particularly ‘destructive scenarios’. In these circumstances, the ECB feels it is now up to European Governments to take advantage of this breathing space and press ahead with ambitious reforms. As it feels the ball is now finally in the court of others, Mr Draghi seemed to say very little new today. However, what he did say might argue that OMTs will in themselves not bring about a notably healthier economic and financial climate in coming months.

ECB interest rates look set to remain on hold until the outlook for economic growth or inflation changes significantly. We still think poor activity data in coming months may prompt one further rate cut around end year but this is unlikely to be a key focal point for markets in the next couple of months. Through this period, the key question may be whether investors will remain optimistic as they have been for the past month about the contribution OMTs can make to calming financial market tensions and reducing uncertainty about the future of EMU.

A Lot Done…

Some sense of how low key today’s ECB press conference was is suggested by the first paragraph of Mr Draghi’s opening press statement. It largely repeated the wording of September’s statement. However, the two final sentences are new and highlight the role the ECB sees being played by the new OMTs;

‘Our decisions as regards Outright Monetary Transactions (OMTs) have helped to alleviate such tensions over the past few weeks, thereby reducing concerns about the materialisation of destructive scenarios. It is now essential that governments continue to implement the necessary steps to reduce both fiscal and structural imbalances and proceed with financial sector restructuring measures.’

These two sentences seem to capture the essence of ECB thinking at present. The ECB see that (i) tensions have eased, (ii) extreme tail risks appear to have reduced significantly and, given this breathing space, (iii) it is now up to Eurozone governments to take the necessary measures to address the many current shortcomings of the Euro area.

To reassure markets further the press statement went on to say

‘The Governing Council remains firmly committed to preserving the singleness of its monetary policy and to ensuring the proper transmission of the policy stance to the real economy throughout the euro area.’

and added that,

‘We are ready to undertake OMTs, once all the prerequisites are in place.’

Though these comments may appear very strong, they are notably more limited than Mr Draghi’s previous assertion that the ECB would do ‘whatever it takes’. Instead the OMTs might be seen as an insurance policy against the possibility of extreme and awful outcomes in the months ahead:

‘OMTs will enable us to provide, under appropriate conditions, a fully effective backstop to avoid destructive scenarios with potentially sever challenges for price stability in the euro area.’

However markets may be somewhat complacent about the range of circumstances in which this insurance policy might become operational and how much cover it will provide. As today’s ECB statement suggests, OMTs address the risk of extreme outcomes such as a forced breakup. These may be an important subset of the problems facing the single currency area but they are only a subset. Indeed it is possible that the removal of this tail risk may result in notably less ambition on the part of Governments in terms of implementing other policies that will support near term adjustments and enhance longer term growth prospects. Markets may begin to focus on such concerns in the month ahead.

Many practical details remain uncertain

It remains unclear exactly when and how forcefully OMTs would be undertaken and Mr Draghi added little to our technical knowledge of the possible operation of OMTs today. Concerns about possible legal challenges to the programme and complicated manoeuvring toward a Spanish bailout argue for some element of caution. That said, there is room for significant differences in interpretation about what OMTs might mean in practice.

We remain completely in the dark about how Mr Draghi or perhaps Mr Weidmann would interpret today’s comment that ‘the Governing Council will consider entering into OMTs to the extent they are warranted from a monetary policy perspective as long as programme conditionality is fully respected’. Mr Draghi refused to give any clear guidance today on what circumstances would trigger the start and stop of bond purchases by the ECB under its OMT programme. In circumstances where some upside risk to inflation emerged across the Eurozone, might the ECB’s monetary policy assessment result in limited or no action in terms of OMTs? At the present juncture, this possibility that may not appear a pressing concern but uncomfortably high inflation in the months ahead could make aggressive activation of OMTs a more contentious issue.

Some Signs Of A More Negative Feedback Between Growth And Austerity

A possibly more immediate problem would be how the ECB would assess a given country’s ‘respect of programme conditionality’. The past couple of months have seen growing signs of a strongly negative feedback between economic growth and Budget austerity in a number of Euro area economies. As a result, there are significant risks that Budget deficit targets will be overshot. In the past, Troika members have differed somewhat in their assessment of the implications of Budget overruns that stem from weaker than expected growth. The IMF have appeared to be more tolerant of such overshooting than either the EU Commission or the ECB as long as countries implemented agreed policy measures. It is not clear how the activation of the ECB’s OMT programme would be affected by slippage in a country’s Budget outcome due to a shortfall in growth. If the ECB were to take a very restrictive view, such slippage might prompt a cessation in ECB bond buying-in which case a negative spiral between growth and budgets would intensify.

We continue to have significant reservations about the ECB’s assertion that OMTs are intended to reduce fragmentation and assist the ‘singleness’ of monetary policy across the Euro area in the light of the decision not to embark on purchases of Government bonds of Ireland or Portugal. Indeed, Mr Draghi appeared to move further away from such purchases when he said today that purchases would not be undertaken until full market access has been completed. If the intention of the OMTs is to reduce market fragmentation, it seems to make little sense for the ECB to only contemplate bond purchases when market rates for a country’s bonds have fallen to levels that make possible its return to market funding. More generally, it seems unusual to hold out OMTs as a support mechanism designed to encourage countries such as Spain to seek formal EU/IMF assistance when current programme countries can only access such support when exiting their programmes. Mr Draghi emphasised that the OMTs were ‘not a replacement for a lack of primary market access’ but that is largely the sort of insurance that financial markets see them providing. In addition, as noted last month, we think the small size of their respective bond markets means that limited purchases of Portuguese and Irish bonds could have an outsized impact and thereby underpin confidence in the OMT programme.

Economic Assessment Broadly Unchanged But Some Tentative Concerns Emerging About Inflation

Today’s ECB press statement and press conference devoted little time or attention to current economic conditions in the Euro area. The ECB continues to see activity remaining ‘weak in the near term and to recover only gradually thereafter’. As Mr Draghi noted, cutting ECB interest rates further was not discussed today. There are several reasons why the ECB is not focussing on further interest rate adjustments at this time. First of all, it sees its announcement of OMTs to address financial market tensions as an altogether more important policy focus at present. Second, ECB policy rates are at historically low levels at present and lowering them further may not have a substantial impact across the Euro are as a whole. Third, while inflation is expected to ease in 2013, the current reading of 2.7% is uncomfortably high for many of those around the table of the Governing Council. Indeed, some more hawkish ECB members will want to see an early easing in inflation if they are not to begin to contemplate the circumstances that might call for any tightening in policy. It should be emphasised that we remain some considerable distance from the possibility of a tightening. Today’s ECB statement indicates that ‘current levels of inflation should thus remain transitory and not give rise to second-round effects. We will continue to monitor closely further developments in costs, wages and prices.’ This phrasing suggests there are no major concerns about inflation at present but it is at very least a complicating factor and it would take sharply weaker than expected activity data to prompt any renewed focus on further rate cuts.

As we see some risk of relatively poor data in coming months we continue to believe a final rate cut might be required at the very end of 2012 or in early 2013. However for the moment, both the ECB and financial markets are focused on the ‘insurance’ provided by OMTs and whether any near term claims will be made on this policy.