Analysis: Exit policy and peripheral crisis key issues at ECB conference

The November ECB press conference was dull even by ECB standards as Mr. Trichet said as little new as he reasonably could despite sharply changing circumstances. Concerns about peripheral countries had mounted, euro zone leaders struggled to find solutions and the US Fed eased its policy as it started a controversial QE-2 program.

However, Trichet decided to play for time and invited the press for an important “rendezvous” in December. So, here we are and the “rendezvous” looks to be far more interesting in many respects than Mr. Trichet might have envisaged one month ago.

In November, the ECB clearly had further steps in its exit policy in mind, but this decision must now be made in very changed circumstances amid a number of various factors that threaten a fully fledged euro zone crisis. How will the ECB respond?

Economic picture improves

Starting with the traditional influence of the economic environment on policy, the ECB will have new staff growth and inflation forecasts. Throughout 2010, the ECB staff has had to revise its forecasts repeatedly up and this is likely to again be the case. The EU Commission yesterday raised its growth outlook and expects now for the period 2010-12, annual growth of respectively 1.7%, 1.5% and 1.8%.

In September, the ECB put its estimates for the 2010 and 2011 at 1.6% and 1.4%. So some moderate upward revision is likely. Inflation forecasts for 2010 and 2011 were revised in September by 0.1%-point to 1.6% and 1.7%, while the ECB also note that the risks to inflation were tilted to the upside. We might see the forecast for 2011 be raised marginally to 1.8%. Looking to the shorter term eco picture, it seems that the softer patch witnessed in late summer may be over and momentum could be building into 2011.

However, within the euro area, there is evidence of a sharply widening gap between the economy of the so-called core countries that are doing surprisingly well and that of the peripherals where budgetary restraint and structural issues are weighing heavily on growth. However, viewed narrowly in terms of the overall growth picture of the area, the ECB should be satisfied by the current pace of growth.

Exit policy in the focus

The ECB took far-reaching liquidity measures when the banking crisis developed. It offered commercial banks unlimited liquidity at its refirate of 1% and lengthened the duration of this liquidity of up to 1-year. In the fall of 2009, the ECB warned that these were emergency measures they intended to reign in gradually.

The ECB feared that banks would get addicted to the ECB liquidity provision. So, the duration of liquidity was shortened by no longer offering 6- and 12 month liquidity. The ECB also intended to shift the 3-month liquidity tenders from full allotment/Fixed rate to fixed allotment/variable rate in a further step to wean the banks from ECB dependence, but, after the bond market crisis of May 2010, it had to revert to full allotment mode.

During 2010, money markets gradually began to function more normally, but banks located in the peripheral countries effectively lost access to the market, increasing their reliance on ECB liquidity. Recently, it seems that lending to Irish banks amounted to about €130B (including some lending by the Irish Central Bank), but also lending to Portuguese and Spanish
banks was surprisingly high.

The ECB became increasingly inpatient with the inability of these banks to fund themselves in the market. We suspect that the ECB increasingly feared that these “emergency” liquidity measures would interfere with their overriding objective of keeping inflation below, but close to 2%. Indeed, in core markets, the economy rebounded much more vigorously and it became increasingly likely that interest rates were no longer appropriate for these economies. The ECB, as a stability-oriented institution, probably feared that its liquidity policy might become a source of imbalances and future problems.

For many months, the ECB has asked governments to take care of the problems of banks in their countries that were on the ECB ‘lifeline’, but apparently governments couldn’t find a solution themselves and continued to rely on the ECB’s status as lender of last resort. While it is of course subject of much speculation, it seems that the ECB decided to look for a desirable and speedy solution, increasingly suggesting that Ireland could ask support from the European Financial Stability Facility. While other factors, such as German Chancellor Merkel suggestions that bondholders should share the burden of future debt restructurings clearly played a role too, ECB “suggestion” didn’t escape the attention of the markets and became a source of additional
instability.

ECB in the midst of yet another crisis

Developments took a further turn for the worse this week as the Irish rescue package didn’t calm tensions in markets. On the contrary, the situation in the peripheral bond markets deteriorated, as contagion fears increased pressure on Spanish and recently also Italian and Belgian bonds.

The situation now threatens to spiral out of hand and push the euro zone in yet another crisis that questions its sustainability.

Content provided by: KBC Bank