ECB Preview

January 13, 2010

The 22-person ECB Governing Council’s announcement at 12:45 GMT Thursday and subsequent press conference in Frankfurt will not reveal more information than provided at the more important December meeting, the final one of 2009.  By consensus, not a unanimous vote, policymakers in December decided not to undertake a fourth 12-month refi operation and to index the third one to weekly auction rates.  For now, other refinancing rates will carry a fixed 1.0% and be unlimited in bids accepted.  There is to be only one more six-month repo operation, which will be undertaken in March.  Officials were unanimous in approving the retention of a 1.0% key refinancing rate, which along with a 0.25% deposit rate and a 1.75% marginal lending rate were called appropriate for Euroland’s macroeconomic circumstances and prospects.

New quarterly growth and price forecasts released by the ECB staff in December accentuated the economy’s continuing weakness.  Real GDP was projected to drop about 4.0% in 2009, then rise between 0.1% and 1.5% this year (a mid-point estimate of only 0.8%) followed by a gain of 0.2-2.2% in 2011.  Projected CPI inflation of 0.3% in 2009, 0.9-1.7% in 2010, and 0.8-2.0% in 2011 stays below the ECB’s target (below but close to 2%) throughout the period.

The hallmarks of ECB monetary policy were clarified in December, and nothing has occurred since to warrant a change.

  • Non-standard measures will be phased out in a gradual, yet progressive and timely manner.  That means whittling down the central bank’s balance sheet, returning eventually to variable rate tenders, and restoring normal, non-crisis criteria for collateral that the central bank will accept.
  • A need continues to promote considerable liquidity to the market as banks clean up their balance sheets.
  • Actions taken in December were in no way intended as an interest rate signal.  Officials were very clear that 1.0% remains the appropriate level, and their macroeconomic signals are consistent with keeping 1.0% until the very final months of 2010 and arguably into the start of 2011.
  • The Council did not wish to influence the yield curve in any way.  Because of quantitative easing and a deposit rate of 0.25%, the overnight Eonia rate of 0.33% remains well below 1.0%.  The phase-out of quantitative easing points to an upward trend in Eonia, but not immediately or at a quick pace.  Such could still lie below 1% a year from now.
  • Perceived risks associated with the new forecasts are balanced, and significant undesirable consequences could result from moving too soon, too quickly, too late or too rapidly.  Officials enter this delicate stage with an open mind and will react appropriately to developing trends in macroeconomic data but not exclusively to such.  Asset prices, commodity prices and financial market conditions will be important policy guides, too.
  • The ECB does not target the euro but takes its value into consideration when formulating a view on the future path of aggregate demand and inflation, factors that will influence the timing of future tightening.  When questioned in December about the EUR/USD value, ECB President Trichet again and again underscored the importance that U.S. officials, specifically Geithner and Bernanke, had verbally expressed the view that dollar strength matters.

Notwithstanding the emphasis on a measured pace of policy change, officials in December acknowledged an inflection point in the monetary policy cycle, which is something short of actual tightening but a more substantive shift than the Fed, Bank of Japan, or Bank of England have done thus far.  The ECB leadership continue to distinguish between the basic thrust of monetary policy and liquidity-providing policy to grease severely impaired financial market conditions.  By compartmentalizing the two objectives, the ECB is able to rein in quantitative easing before core CPI has bottomed and despite a forecast of sub-target total inflation for the entire forecast horizon and sub-trend growth in 2010.

Data released since the December 3rd meeting underscored the fragility and unevenness of Euroland’s economic recovery. 

  1. A preliminary 5% estimated drop in German GDP last year suggests no growth in the final quarter of the year following positive rates of expansion in both 2Q and 3Q.
  2. Industrial production and orders for the whole bloc fell in October by 0.6% and 2.2%, and they posted on-year declines of 11.1% and 14.5%.
  3. German industrial production and orders in November were weaker than assumed.  Domestic capital goods orders in October-November were 5.7% lower than their 3Q level, which points to subdued business investment ahead.
  4. Real GDP rose 0.4% (not annualized in 3Q) according to revised figures, but real domestic final sales fell.  Inventories accounted for all of the growth, and net exports made a modest positive contribution.
  5. Retail sales volume sank 1.2% in November and was 0.8% lower in October-November than the 3Q mean.
  6. Construction output slid 0.6% and 7.7% on year in October.
  7. M3 and private lending posted on-year declines of 0.2% and 0.7% in November, while private credit growth slowed to a 12-month gain of 0.4% from 1.0% two months earlier.
  8. After a devastatingly sharp recession, Euroland has huge amounts of unused resources.  Unemployment climbed to 10.0% in November from 9.6% in August and 8.0% a year earlier.  Estimates of the bloc’s output gap, combined with the ECB’s soft projections of future growth, suggest that an output gap will persist into 2012.  And when aggregate supply exceeds aggregate demand, the trend for inflation is often southward.
  9. Total CPI inflation returned to the black with on-year rates of 0.5% in November and 0.9% in December.  However, that reflects energy developments.  Core inflation is 1.0% presently and still working its way lower.  Producer prices fell 4.4% in the year to November.  Non-energy producer prices dipped 01% on month in November and fell 3.1% from a year earlier.  Hourly earnings growth slowed to an on-year pace of 3.2% in 3Q09 from 4.3% in 2Q, with both wages and benefits contributing to the deceleration.
  10. The brightest spots in Euroland’s economic scene are coming from the purchasing managers indices and gauges of economic sentiment.  The composite PMI rose to 54.2 in December from 53.7 in November and 50.4 last August.  Economic sentiment last month printed at 91.3, up from 88.8 in November and 80.8 in August.  Over the final third of the year, consumer sentiment and industrial sentiment respectively improved 6 points and 9 points to reading of minus 16 in each instance.  The Sentix Investor Confidence index printed at minus 3.7 in December after minus 5.5 in November.

Like Japan but not the United States, Euroland’s recovery continues to be critically dependent on export demand.  How the economy responds to cutbacks in fiscal stimulus and more elevated long-term interest rates and commodity prices pose key uncertainties that ECB officials will have to monitor carefully.

The euro since the December meeting has fallen 4.2% on a trade-weighted basis and 3.2% against the dollar.  Ten-year bund yields are 16 basis points higher now, and oil prices are up 4.5% despite some backsliding in recent days.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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