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Expectations were very high ahead of today’s ECB Governing Council meetin
Yet again expectations were very high ahead of today’s ECB Governing Council meeting. Admittedly, the broad parameters of the ECB’s new bond buying programme had been signalled through a number of media leaks in recent days. However, there has been a longstanding tendency for European policymakers to deliver somewhat less than anticipated on this sort of occasion. So, Mr Draghi’s announcement of the details of what are termed ‘the Outright Monetary Transactions (OMTs)’ was keenly awaited.
In broad terms the main features of the OMTs are as had been suggested in recent media reports. The tone of Mr Draghi’s comments today seemed to be intended to ease ‘Germanic’ concerns that the ECB would act in a manner that might be at odds with the spirit if not the letter of its mandate. This also reflects a significant effort to appease the single voice on the Governing Council who dissented from today’s decision. So, there was a strong emphasis on the ‘conditionality’ of the new bond purchase programme.
At the margin, there were some slightly surprising aspects to Mr Draghi’s comments today that may hint that the new programme will be implemented more sparingly than many in the market might expect. Mr Draghi said the OMTs are designed to be a strong backstop that eliminates ‘tail risk’ in the Euro area. Initial market reaction appears to suggest the ECB has been successful in encouraging confidence in this view. However, Mr Draghi also said OMTs were designed to ‘safeguard an appropriate monetary policy transmission mechanism and the singleness of monetary policy’. The differentiated treatment of Portugal and Ireland seems to run completely contrary to this stated purpose. It appears the OMTs for these countries will only be considered when they really no longer need them—when they are about to exit their EU/IMF programmes. If the idea of the programme is to address ‘fragmented’ conditions, it makes no sense to only implant it when countries have overcome such obstacles and are on the point of restoring access to market funding. This approach seems difficult to understand.
In contrast to the ‘segmented’ approach there would seem to be a strong rationale for equal treatment for all eligible countries and for early ECB action in regard to Portuguese and Irish debt in order to underscore a commitment to the OMTs. This might be a relatively fruitful approach because the amount of outstanding debt with a current maturity of less than three years in these two countries is relatively small. So, any ECB intervention might be expected to have a substantial effect on the respective market yields. The ‘demonstration effect’ of such purchases might also have a significant impact on market expectations of the possible consequences of potential ECB action in relation to Spain and Italy.
So technically and tactically, ECB action in the Portuguese and Irish markets would seem to have much to commend it. This makes it even more difficult to explain why the ECB would seem to have decided to implement OMTs in a significantly different manner in relation to Portugal and Ireland than appears to be signalled for countries such as Italy and Spain.
Apart from this potentially troublesome aspect, the main elements of the new OMTs announced by Mr Draghi today are along expected lines:
The ECB Also Loosens Collateral Terms
The announcement of the new OMTs was undoubtedly the centrepiece of today’s ECB press conference but Mr Draghi also announced a loosening of the terms of collateral eligibility in the ECB’s credit operations. As Mr Draghi noted, this was intended to ensure ‘the availability of adequate collateral in Eurosystem refinancing operations’. This loosening took two forms. First of all, the ECB decided to suspend credit ratings agency’s minimum thresholds. This change should prevent any substantial deterioration in access to ECB facilities in the event of further downgrades. Second, the ECB decided to re-allow the eligibility of US dollar, sterling and Japanese yen instruments as collateral in Eurosystem operations. Today’s loosening of collateral rules has occurred against a build-up of concern about a scarcity of eligible collateral in some parts of the Euro area. While these measures will be helpful, they are unlikely to have a dramatic impact should market sentiment sour markedly.
ECB Downbeat On Economic Outlook
Mr Draghi also presented new ECB staff projections for economic growth and inflation today. These show a downgrade of growth prospects and an upward revision to the inflation outlook relative to the previous projections released in June. The alteration to the growth forecast for 2012 is broadly as expected (The midpoint of the staff range for GDP is now put at -0.4% against -0.1% in June). This reflects persistent evidence of a weakening in the trajectory of activity as we approach the end of the third quarter. Significantly, recent evidence also points to a notably softer growth outlook for Germany. Of far greater importance, the ECB anticipates only a very limited improvement in European economic conditions through 2013. The midpoint for GDP growth for next year is now put at 0.3% compared to 1.0% in June.
With oil prices higher in Euro terms of late and budget measures likely to boost inflation in a number of countries, it is not too surprising that the ECB’s inflation projections have moved higher. The 2012 inflation projection has been revised up marginally but a more notable change is to 2013, where the midpoint of the projection has been revised up to 1.9% from 1.6%. This is still consistent with the ECB’s policy goal of achieving an inflation rate of below but close to 2% and today’s ECB press statement also emphasises that inflation will ‘remain in line with price stability over the policy-relevant horizon’.
Rate Cut Will Require More Signs Of Weakness
Today’s projections may make some of the more hawkish members of the ECB reluctant to contemplate a further reduction in interest rates. In this context, Mr Draghi said that the question of lower interest rate had been discussed by the Governing Council today but it was felt that it was ‘not the right time’. In addition to today’s higher inflation forecast, this judgement may owe something to an unhelpful rebound in inflation to 2.6% in August from 2.4% in July. Mr Draghi rationalised today’s decision to keep rates unchanged by saying the ECB had already anticipated some deterioration in the economic environment when it cut rates in July. That said, the ECB still sees the risks to its current outlook for growth as weighted to the downside. In addition, its usual listing of two way risks to inflation included reference to a concern that the intensification of financial market tensions ‘has the potential to affect the balance of risks on the downside’. One interpretation of these comments might be that the ECB is holding a further interest rate cut in reserve against the threat of weaker economic data and/or increased market turmoil in the coming months. For this reason, the prospect of another rate cut before end year remains in place.