Mixed Message from the ECB, and Markets Weaken in Response

December 8, 2011

The good news was a rate cut of 25 basis points, downwardly revised forecasts of inflation, and a number of unconventional measure modifications to facilitate the transmission of policy.  The ECB, for instance, will now do a few three-year fixed rate refinancing operations, exceeding the prior limit of a one-year maturity.  Rules on eligible collateral at the ECB are being loosened.  The reserve requirement ratio is being halved to 1% in January.  The Governing Council has agreed to act as an agent for the EFSF.  The adjustments to unconventional measures were summarized in a separate press release.

The new interest rate structure has returned to that prevailing from May 2009 until April of this year and offsets tightenings of 25 basis points each in April 2011 and July 2011.  The structure again features a 1.0% refinancing rate, flanked by a 0.25% deposit rate and a 1.75% marginal lending rates.

ECB President Draghi’s formal statement unveils new macroeconomic forecasts, as the ECB routinely offers on a quarterly basis.  The new growth projection for 2012 is a range centered on 0.3%, down from range midpoints of 1.3% presented in September and 1.7% presented six months ago.  The projected growth boundaries in 2013 run from a low of 0.3% to a high of 2.3%.  The CPI inflation forecast for 2012 was raised slightly to a midpoint of 2.0% from 1.7% predicted three months ago due to higher commodities.  The mid-point of the expected CPI range in 2013 of 1.5% lies below the ECB definition of price stability as below but close to 2.0% and therefore leaves the door open to possible additional stimulus, but Draghi asserted that a greater-than-25 bp rate cut today had not even been considered by the Governing Council.  The table below shows the evolution of the ECB forecasts, the date in the left-most column being the time when each forecast was released.

  GDP 2011 GDP 2012 GDP 2013 CPI 2011 CPI 2012 CPI 2013
12/11 +1.5/1.7% -0.4/+1.0% +0.3/2.3% +2.6/2.8% +1.5/2.5% +0.8/2.2%
09/11 +1.4/1.8% +0.4/2.2%   +2.5/2.7% +1.2/2.2%  
06/11 +1.5/2.3% +0.6/2.8%   +2.5/2.7% +1.1/2.3%  
03/11 +1.3/2.1% +0.8/2.8%   +2.0/2.6% +1.0/2.4%  
12/10 +0.7/2.1% +0.6/2.8%   +1.3/2.3% +0.7/2.3%  
09/10 +0.5/2.3%     +1.2/2.2%    
06/10 +0.2/2.2%     +0.2/2.2%    
03/10 +0.5/2.5%     +0.9/2.1%    
12/09 +0.2/2.2%     +0.8/2.0%    


Although averaging 2.0% next year, inflation is expected to fall through that level during the course of the year.  Without actually using the R-for-recession word in the introductory statement, the growth prognosis is said to be associated with “high uncertainty” and “substantial downside risks.”  Moreover growth, which was below 1% annualized in 2Q and 3Q, is forecast to weaken in the period ahead, and Draghi himself has conceded a mild recession in spoken words.  The bottom line of “modest price, cost and wage pressures over the policy-relevant period” suggests a central bank policy that, in the right circumstances, will cooperate with other actions to promote growth and preserve the EMU.  Moderate monetary and credit growth trends do not countermand the conclusions of a low and stable inflationary environment from the ECB’s economic analysis. 

All this good news was undermined by unsettling body language in the press conference.  Time and again, Draghi spoke of adhering to the spirit of the treaties establishing a common currency in Europe and a single monetary policy.  That emphasis puts the predominant onus for saving the system on fiscal policy, not monetary policy, and rejects a lender-of-last-resort role for the ECB.  It is a formula that doesn’t address current account imbalances, which are the root cause of the crisis, nor provide a means for uncompetitive members in Euroland to become not so labeled.  Endless deflationary fiscal drag continues to be the favored recipe for vulnerable members of EMU, and that’s an answer that will not be sustained politically forever.  So investors are right to worry that European monetary union could be a doomed marriage –maybe not today.  maybe not tomorrow, but in all likelihood sooner rather than later.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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