The ECB appears more confident that the Eurozone economy is beginning to stabilise

• Mr Draghi suggests economic outlook a little less gloomy
• Further interest rate cut will require evidence of renewed economic deterioration
• We still see downside risks – as today’s Bank of England easing highlights
• As a result, a further rate cut could still come before mid year
• Key near term issues for ECB are Greece and February’s LTRO
• Draghi encourages strong uptake of 3 year liquidity to guard against credit crunch
• Draghi tight-lipped on Greece but silence suggests some form of ECB contribution is likely.

As expected, the European Central Bank left its key interest rates unchanged today. The tone of comments from ECB President, Mario Draghi, at the regular press conference that follows the monthly policy meeting of the ECB’s Governing Council suggests another rate cut is neither imminent nor automatic.  The ECB appears more confident that the Eurozone economy is beginning to stabilise. This means it will likely take very clear evidence of a renewed weakening in activity to prompt a further cut in policy rates.  We still think signs of a further deterioration may begin to build through the spring. This means another ECB rate cut could be contemplated before mid year.

In the mean time, the ECB is far more focussed on two formidable tasks. First of all, Mr Draghi must walk a very fine line in contributing to a solution in the latest round of Greek difficulties without compromising the credibility of the ECB. Second, the ECB must also ensure its liquidity operations (a) reduce the threat of a credit crunch, (b) avoid the risk of a Lehman’s-like moment for any financial institution and (c) assist an increase in financing capacity to the ‘real’ economy.

The difficulties still facing the Eurozone economy and its financial system mean the second hundred days of Mr Draghi’s presidency of the ECB are unlikely to be notably duller than the first hundred. That said, there is a sense from today’s press conference that a good deal of progress has been made of late and that the next couple of months will concentrate on the practical implementation of significant policy adjustments that have already been made.

ECB Sees Economy Stabilising

One important reason why any change in interest rates may seem further away is that the balance of evidence from the batch of indicators released in the past month seems to back up the ECB verdict that ‘tentative signs of stabilisation in economic activity’ have become apparent since around the turn of the year.  The fact that activity is no longer in freefall probably also led the ECB to remove the word ‘substantial’ from what it now regards simply as ‘downside risks’ to the outlook. As a result, in response to a question about interest rate policy, Mr Draghi said that the Governing Council meeting ‘didn’t discuss any prospective or current change in interest rates’.  This represents quite a shift from a response given to a question at the January press conference that acknowledged that ‘uncertainty is very high and we will monitor all developments and stand ready to act’.  We interpret this change as signalling greater confidence about the near term economic outlook on the part of the ECB but there are still several reasons why another rate cut shouldn’t be ruled out.

The ECB is monitoring broadly similar information to that being pored over by the US Federal Reserve and the Bank of England. We have seen in recent days a reiteration of the Fed’s concern about the health of the US recovery in spite of some encouraging jobs data last week. Today also saw the Bank of England decide to implement a further easing by increasing its asset purchase scheme by a further £50 billion from £275 billion to £325 billion.  In explaining this decision the Bank of England noted that ‘the pace of expansion in the United Kingdom’s main export markets has also slowed and concerns remain about the indebtedness and competitiveness of some Euro area countries’. While the ECB may be relieved that recent indicators weren’t notably worse it still acknowledges that risks lie to the downside in what it sees as an economy ‘recovering very gradually’ from the current ‘low level’ of activity.  Apart from the looming impact of increased budget austerity in a range of economies (which the ECB perhaps not surprisingly doesn’t highlight), there is also a threat to activity from evidence of a weakening in lending in December data.  This may point to a potentially significant tightening in credit conditions but the ECB not unreasonably emphasises ‘the impact of the first three year LTRO is still unfolding’ and other measures ‘are still to be implemented’. As a result, the ECB seems to have upgraded the significance it attaches to bank lending data to the point that ‘close scrutiny of credit counterparts in the period ahead is essential’.

For these varied reasons, we still see a decent prospect of a further ECB rate cut in the second quarter.  Importantly, such a course of action will require compelling evidence of a renewed weakening in the Euro area economy even if the ECB will be equally keen not to close the door to a further easing.

Both liquidity operations seen easing financing concerns

With policy rates at historically low levels, the ECB rightly feels it should give more priority at present to some other critically important issues. Mr Draghi again highlighted today the significance the ECB attaches to its three year long term refinancing operations, the first of which took place in late December and the second of which is scheduled for the end of this month. Mr Draghi attempted to encourage a substantial uptake at the LTRO by downplaying any sense of the stigma that has traditionally attached to funding from Central Banks.

In recent weeks some wild and wonderful estimates have surfaced in relation to the likely uptake at the end February LTRO. Mr Draghi said today that he was not certain how much liquidity banks would seek.  However, he did suggest that it might be around the same as that seen in December. So, it would not seem unreasonable to expect a figure of around €500 billion. While this may be smaller than some estimates, it still constitutes a significant liquidity add. Moreover, speculation may turn to the possibility that further very long term liquidity operations could be undertaken if circumstances require. Again, now that the ECB has added to its armoury even such a possibility should support sentiment towards the Eurozone financial system.

Mr Draghi also hinted that there have been some disagreements on the Governing Council as to the breadth of the looming LTRO. Although, he said the decision was not unanimous he indicated there had been broad agreement, a phrasing that probably chimes with recent comments by Bundesbank prescribed Weidmann on the risks to financial stability posed by excessive liquidity. A subsequent ECB press statement indicated that seven national central banks – those of Austria, Cyprus, France, Ireland, Italy, Portugal and Spain had put forward proposals in this area. As we noted in our December ECB comment, this approach allows for significant differences in countries’ circumstances as well as the structure of lending but it also further ‘nationalises’ the financing of banks within the Eurozone. We also think it noteworthy that Mr Draghi continues to downplay any expectations that these actions will lead to a strong increase in lending.  Such a message would seem appropriate for a range of audiences. It will reduce worries in those fearful of a rise in inflation and it will dampen any thoughts that it will markedly boost economic prospects in weaker economies. More importantly, it seems to reflect a view that the key contribution this and other unorthodox actions can make is to significantly diminish the threat of any nasty unforeseen credit event in the Eurozone.

Mr Draghi’s pregnant silence on Greece

Probably the most interesting aspect of today’s press conference related to what Mr Draghi didn’t and wouldn’t say. Asked repeatedly about any ECB participation in the latest Greek financing initiative, Mr Draghi refused to be drawn. While he emphasised a strong and complete opposition to monetary financing of Greece by the ECB, the precise wording of his replies didn’t exclude a willingness to provide some form of assistance. Mr Draghi highlighted the importance of both the fiscal compact and the (emerging) Greek agreement. So, it seems very clear that a Draghi-led ECB is willing to be pragmatic once it is fully convinced that lasting and irreversible reforms have been undertaken. In that context, his repeated comment that any loss the ECB took on its bond holding would equate to monetary financing seems to allow for the possibility that the ECB could resell bonds it purchased under its Securities Market Programme at their purchase prices and avoid violating its constitution. The likelihood is that the precise contribution that the ECB may make will probably only be decided once (1) the Greek Parliament have voted for the additional austerity measures required by the new programme, (2) agreement on the private sector haircut is concluded and (3) the Troika deliver a favourable report on the latest developments. Mr Draghi has signalled a willingness to play some role but has skilfully retained significant leeway to pressurise for further concessions from the other key players. This stance will probably give markets a greater sense of confidence in the ECBs capability to steer a delicate path between retaining its credibility and remaining relevant at a time of great stress. As a result, while today’s ECB press conference provided little in the way of fireworks, it will have further underpinned market confidence in Mr Draghi’s stewardship.