There were no expectations of any major change in ECB policy

• ECB less concerned about activity but some monetary policymakers concerned about inflation.
• Draghi press conference comments at odds with more hawkish tone of monthly statement.
• Draghi downplays immediate inflation concerns and possibly of near term policy change.
• Is the strength of the German economy causing discord over ECB policy stance?
• Worries about budget adjustment fatigue also becoming an issue for Frankfurt.
• Draghi reiterates strong ECB line on Irish promissory notes.

There were no expectations of any major change in ECB policy or thinking ahead of today’s monthly Governing Council meeting.  With key interest rates left on hold and no dramatic pronouncements from ECB President Mario Draghi at the ECB’s monthly press conference, the immediate market reaction was minimal.  The tone of Mr Draghi’s comments suggests the ECB sees itself remaining on the sidelines for some time to come.  That said, there were some signs of subtle changes in ECB thinking of late and some further hints of potentially significant differences of opinion around the table of the Governing Council.

The most immediate implication of Mr Draghi’s press conference is that the ECB is in analytical rather than action mode.  Mr Draghi said that rate changes weren’t discussed today and that there had been no substantive change in ECB thinking in the past month.  Mr Draghi repeatedly suggested that the ECB’s long-term refinancing operations are ‘powerful complex measures’ whose effects may take some time to assess.  Furthermore, while the outlook for activity or inflation are not immediately threatening, in both instances significant uncertainties remain that counsel against hasty action.

Mr Draghi also downplayed the significance of the recent ending of the requirement on all National Central Banks to take Bank bonds of EU/IMF programme countries or others of non-investment grade.  He said cross-country holdings of these bonds were so small as to make them irrelevant.  He colourfully added ‘we’re really talking about peanuts!’  Mr Draghi also said the ECB would monitor whether it is appropriate to continue covered bond purchases in current conditions.

There were some potentially significant if subtle changes to the ECB’s press statement in regard to inflation even if Mr Draghi sought to downplay their relevance to the immediate policy outlook.  Building on the March statement, the ECB appears notably less worried about the outlook for activity and somewhat more concerned about inflation risks.  As we argued in last month’s commentary, this partly reflects an understandable almost reflex response on the part of the ECB.  Having taken drastic action to reduce downside risks to activity and the financial system in late 2011, the ECB may feel it needs to convince markets and some of its own monetary policymakers as well as the broader population that it won’t take risks on inflation.

Although recent Euro area economic data have been mixed, the ECB emphasised the positive; suggesting these point towards ‘a stabilisation of economic activity at a low level in early 2012’ and also anticipating ‘a moderate recovery’ (the same phrasing that the US Federal Reserve has used to describe a seemingly healthier trajectory in the US economy of late).  Admittedly, the ECB still acknowledges that ‘downside risks to the economic outlook prevail’ but the thrust of the press statement and the subsequent press conference suggest the ECB feels these risks are diminishing.  This all but removes the possibility of a further interest rate cut barring a dramatic (but not entirely impossible) renewed deterioration in economic conditions.

If the ECB’s concerns about economic activity have eased, the most significant aspect of today’s press statement is a suggestion of some increase in nervousness about inflation.  In part, this represents an understandable desire not to undermine its credibility in the light of the aggressive action taken in late 2011.  However, there also seems to be an inherent nervousness about the current above target inflation reading and the possibility that this could become embedded within the economy at a time when there is significant monetary accommodation.

It is important to preface our own comments on these changes in ECB thinking on inflation by highlighting how different the tone of Mr Draghi’s comments at the monthly press conference were to those of the press statement.  In other circumstances, it might be suggested that Mr Draghi had little role in the drafting of the ECB press statement.  Our judgement is that subtle but important differences between his remarks today and the press statement that preceded them hint at significant differences of opinion within the Governing Council.  Mr Draghi was at pains to suggest that the ECB wasn’t stepping up to its rhetoric on inflation.  He added on a number of occasions that inflation expectations were in line with price stability, that given present conditions with unemployment at historic highs that there seemed to be no strong threat of accelerating inflation.  Reflecting these strong comments, we think we remain some considerable distance away from an ECB rate hike.  However, today’s ECB press statement taken in isolation is more threatening.  It suggests that some of those on the Governing Council find inflation risks have begun to increase to the point where they warrant serious attention.  In one sense, these remarks remind us of ECB thinking when it raised its key interest rate a year ago.

The changes in the tone of ECB press statement comments in relation to inflation were modest but there were four separate areas of today’s text that differed from last month.  First of all, in the opening paragraph the sequencing of comments about inflation and the economic outlook was reversed from that of last month with inflation now being discussed ahead of the remarks on activity.  Second and of greater importance, comments on the medium term outlook for inflation were merged into a single paragraph with a discussion of the various policy measures – both standard and non-standard – implemented in the past few months.  Possibly to allay worries that these actions would lead to an eventual surge in inflation (and some academic commentaries that have argued the ECB’s capacity to tighten policy has diminished) this paragraph now concludes by emphasising the ECB’s capacity to act ‘in a firm and timely manner’.  Interestingly, the previous two occasions this phrase appeared in the ECB press statement were in March and June just before last year’s two ill fated interest rate increases.

A third ‘new’ reference to inflation risks indicates that ‘we (the ECB) will pay particular attention for any signs of pass-through from higher energy prices to wages, profits and general price setting'. Again, this would tend to suggest a step-up in the ECB focus on inflation.  The inclusion of these particular comments in the week following a German public sector pay deal that results in a 6.3% wage increase over two years might suggest a degree of concern about a wage price spiral in the Eurozone’s largest economy.

Again, this would tend to suggest a step-up in the ECB focus on inflation.  The inclusion of these particular comments in the week following a German public sector pay deal that results in a 6.3% wage increase over two years might suggest a degree of concern about a wage price spiral in the Eurozone’s largest economy when Germany undertook a difficult internal adjustment, logic would suggest ECB policy would be too loose for Germany in the coming months and years.  Understandable concerns about such a prospect on the part of the German policymaking establishment appear to be generating some significant divisions about the appropriate policy setting for the ECB and the timing, manner and pace of an exit strategy from the current accommodative setting.  This could be a key issue for the ECB in the next year or so.

Another sign of increased discomfort within the Governing Council was suggested by a subtle change in the press statement in relation to budget policy across the Euro area.  March’s reference to a need to ‘make further progress’ have been replaced by a tougher demand that Governments ‘restore sound fiscal position’ and ‘fully meet their responsibilities to ensure fiscal sustainability’.  When asked about the recent uptick in bond yields in a number of countries, Mr Draghi responded strongly that by and large recent developments were not a sign of ‘market fragility’ but rather that ‘markets are expecting reforms’ and a sign of a return to ‘market attention in the fundamentals’.  Clearly the ECB is concerned that a measure of budget adjustment fatigue has started to emerge in recent weeks and this could threaten the path of deficit reduction in a range of countries’.  To the extent that this points towards a possible collision course with a range of Finance ministers, it points towards a troubling period ahead.

While the relatively relaxed comments on inflation made by Mr Draghi in response to questions at today’s press conference were at odds with the tone of the press statement itself, he did offer some clues as to what the ECB is watching in order to determine the progress or otherwise made by the LTRO’s in restoring normality to the banking system.  He said the ECB is monitoring bank balance sheets country by country to see if the additional liquidity translates into deposits, purchases of assets or lending.  He also said the ECB is closely watching the Target 2 balances though presumably this is as an indicator of increases or decreases in national financing difficulties rather than as a broader metric of imbalances in the Euro area.  These considerations suggest that a clearer assessment of the success or otherwise of the LTRO’s may start to become available to the ECB within a matter of weeks (given the second LTRO became effective early March).  However, it could still be some significant time before it becomes entirely clear whether risks to activity or inflation have shifted in a way that argues for an adjustment in policy.  Today’s ECB press statement suggests some at the ECB have begun to at least contemplate an eventual change in the policy setting but as Mr Draghi repeatedly emphasised that any consideration of a policy change (in either direction) was premature, markets may take a little time before beginning to think about when and how the ECB next acts.

PS
Another sign of a less conciliatory ECB emerged in Mr Draghi’s responses to a number of questions relating to the Irish Government’s efforts to restrictive promissory notes related to IBRC (the vehicle created to wind down the former Anglo Irish Bank and Irish Nationwide Building Society).  Mr Draghi could not be drawn much beyond rehashing the sentiments expressed in a terse ECB statement issued late last week that indicated ‘it is of the utmost importance that the commitments of the Irish State are met in line with outstanding contracts and commitments’.  While it is understandable that the ECB would not want to be drawn ahead of a final agreement between the Irish Government and its European partners and Mr Draghi also emphasised the ECB think Ireland has a very good chance of returning to market funding, the strong message is that the ECB appears unwilling to play a pivotal role in resolving what is a vexed issue in Ireland ahead of an important referendum on the fiscal compact.  In circumstances where the ECB also appears more concerned about inflation and fiscal slippage around the Euro area, the scope for a significant new initiative in this area on the ECB’s part seems very limited at present.  Hence, the increasing focus on possible solutions that minimise ECB involvement.