The ECB kept its key interest rates unchanged at its Governing Council policy meeting

• Further ECB rate cut will require notably poorer economic outlook.
• Inflation not yet an issue but may be troubling some in Frankfurt.
• Draghi keen to emphasise how successful LTRO’s have been…
• … And keeps options open in regard to future actions.
• After aggressive action, Draghi tries to soothe German concerns as differences surface (again).

As expected, the European Central Bank kept its key interest rates unchanged at its Governing Council policy meeting today.  At the regular monthly press conference Mario Draghi, the ECB President sent a fairly clear message that further interest rate cuts are very unlikely unless there is a marked deterioration in economic circumstances.  We wouldn't entirely rule out renewed difficulties prompting a further rate cut by mid year but the bar for such actions has been raised substantially.

Today's changes in the ECB’s assessment of economic and financial conditions were relatively modest but it appears they are less fearful about the economic outlook, a little more concerned about inflation and increasingly confident that the two tranches of three year funding they provided to Euro area banks in December and last week will help stabilise the Eurozone financial system.

Having fought fires in recent months, Mr Draghi has now turned his hand to mending fences.  A key element of today’s press conference was a determined effort to ease concerns about recent radical ECB actions among important groups within German policymaking and public opinion.

While no interest rate change was envisaged, today’s ECB press conference was eagerly awaited for new ECB staff projections as well as an initial assessment of the second three year LTRO implemented last week.  The tone of comments on both of these topics suggested the ECB envisage no further policy action being taken in the near term.  Mr Draghi was very careful not to box himself in – he emphasised the continuing uncertainty in the current environment, casually repeated the long standing mantra that the ECB does not pre-commit and altogether more pointedly refused to answer questions relating to the possibility of a further exceptional LTRO.  However, he also made it clear that the ECB sees itself on the sidelines for some time as it assesses the impact of the aggressive actions it announced in the final two months of 2011.

ECB Sees Slightly Weaker Growth

While the projections are prepared independently of the Governing Council, there is usually a coherence between the numerical forecasts and the policy message the Governing Council seeks to send.  As expected, the ECB revised downwards its projections for Eurozone economic growth for 2012 (to a centre-point of -0.1% from +0.3%) and 2013 (to 1.1% from 1.3%).  These revisions were relatively modest and leave the ECB more positive on 2012 than most in the market and slightly less positive than many for 2013 (although they are in line with last month’s growth projections from the ECB’s professional forecasters survey).  The new growth forecasts reaffirm the view that activity will be very weak in 2012 – but not catastrophically so.  The emerging recovery is also likely to be relatively subdued.  Indeed the Governing Council still see downside risks to growth.  So, the new growth projections appear completely consistent with an unchanged policy stance on the part of the ECB.  Activity is not so poor that it requires further stimulus while the recovery next year is seen sufficiently subdued to justify the persistence of what Mr Draghi confirmed was an ‘accommodative’ monetary policy.

Inflation Becoming a Slight Concern

The ECBs new inflation projection is slightly more surprising.  Inflation is expected to be significantly higher in 2012 (2.4% midpoint v 2.0% previously) and 2013 is also marginally higher (1.6% v 1.5%) even though base effects from the higher 2012 outturn might have been expected to depress next year’s number.  Mr Draghi provided a somewhat unusual depiction of the risks around those new projections.  Although in the near term the ECB sees "...upside risks prevailing.  Nevertheless, we expect price developments to remain in line with price stability over the policy relevant horizon".

The profile of the new inflation forecasts also argues against a further policy easing in the near term.  Instead, it could be suggested that by acknowledging near term inflation risks, the ECB also introduces the very remote possibility that should price pressures become embedded that the door to an eventual rate increase has been opened.  That said, Mr Draghi repeatedly emphasised his view that inflation would remain subdued.  However, the new projections also serve to remind markets that the ECB’s policy remit means it remains firmly focussed on inflation.

ECB Views LTROs as a Significant Success

The new staff projections provide a rationale for an unchanged ECB policy stance and, consequently, don’t signal any dramatic change in economic circumstances in the Euro area.  However, Mr Draghi’s was notably upbeat and very detailed in his assessment of the impact of the ECB’s two year long term refinancing operations.  Speaking at the press conference, he went a good deal further than the monthly press statement’s verdict that ‘the first impact of these measures has been positive’.  Mr Draghi described the LTRO’s as ‘an unquestionable success’ saying that ‘great progress has been achieved’.  He went on to highlight the ‘powerful effect of removing tail risk’ from financial markets.  He also indicated that the effects of the LTRO’s were ‘powerful but also complex’.  So, he has bought time to further assess the impacts on the banking system and the broader economy.

Given that Mr Draghi was so upbeat about the impact of the LTRO’s, it is significant that he repeatedly refused to be drawn on whether such actions would be repeated in the future.  Given the still fragile nature of financial sentiment, Mr Draghi was clearly careful to avoid closing any doors that might need to be re-opened in the future.  Instead, he sought to downplay concerns that the largesse of the LTRO’s would pose economic or financial stability risks.  He also went to unusual lengths to correct what he said was an error made by the Wall Street Journal in its assessment of the risks posed by a larger Eurosystem balance sheet.  Mr Draghi said important differences in the composition of Central Bank balance sheets made the balance sheets of the Federal Reserve and Bank of England ‘leaner’ than that of the ECB.  He went on to suggest the more appropriate measure of the growth in balance sheets was only 15% in the case of the ECB against 19% in the US and 21% in the UK.  He also noted that 460 of the 800 banks taking part in last week’s LTRO were German and that some €40 bn of the €53 bn in credit claims used in the LTRO reflected actions taken by French banks largely to increase their collateral for precautionary purposes.

We provide detail of Mr Draghi’s extended commentary on the LTROs because his remarks seem to have two distinct and important purposes.  First of all, Mr Draghi wanted to emphasise the success of this action to underpin confidence in the Eurozone financial system  Second, he wanted to ease some ‘core’ Eurozone concerns that a flood of money would not translate into runaway inflation or an excessive transfer to the peripheral countries.  Although the LTROs have been successful in underpinning market confidence, Mr Draghi acknowledged that while interbank markets had started to function again, transactions were limited to very short lending periods and by national boundaries.  Similarly, he was guarded in response to questions as to the impact on funding for small and medium enterprises in the ‘real’ economy.

Mr Draghi Seeks To Ease German Concerns

If changes in today’s new economic projection weren’t dramatic and Mr Draghi’s comments on the LTRO’s were perhaps understandably enthusiastic, there was an important subtext in the ECB Presidents’ comments on these matters that found a fuller expression when he was asked about the recent leaking of a letter to him from Bundesbank Chief Jens Weidmann that was critical of recent non-standard ECB actions and requested their early reversal.  It should be emphasised that Mr Draghi didn’t bow to this criticism and, as noted above, potentially refused to rule out further exceptional LTRO’s.  However, a significant portion of the press conference and it might even be argued the tonal change in today’s comments on the economy and inflation seem designed to appease German concerns.  Again, the introduction of exceptional measures has prompted public criticism in Germany (along lines that in previous episodes led to the resignation of two senior German ECB officials).

There is no question that the aggressive actions taken by the ECB of late have not been directed primarily at the current needs of the German economy or its financial system.  That said, it could be argued that unease about these measures in Germanymay reflect an excessively simplistic view of the likely consequences for the German economy and its banking system of an economic or financial meltdown elsewhere within the Eurozone.  If the ECB’s recent strong actions were primarily directed elsewhere, today’s sweet words were largely intended to reassure a German audience.  This was done in a range of ways.  Mr Draghi rejected suggestions that the Bundesbank was isolated within the ECB.  While downplaying the recent German concerns about the operation of the Eurosystem’s clearing system (Target 2), he diplomatically acknowledged that balances at national central banks might reflect structural imbalances within the Eurozone.  Finally, it could even be argued that the ECB’s new forecasts for growth and inflation are quite sympathetic to German assessments of current economic circumstances.  Through these various interventions, Mr Draghi appeared to try to ease German concerns.

Arguably the most notable aspect of today’s press conference is that Germany figured more prominently than Greece.  This suggests there are significant tensions within the ECB that reflect more general differences of opinion across Europe as to what next needs to be done to ensure lasting stability in economic and financial conditions in the Eurozone.  Today’s ECB press conference saw Mr Draghi attempt to reassure that the ECB remains cautious and conservative.  However, the emphasis was on reassurance rather than any re-evaluation of policy.  The ECB President will need to remain at his diplomatic best to ensure markets don’t begin to fret about difficulties the Eurozone may face in taking comprehensive and cohesive policy action.