ECB Preview

October 3, 2012

Most analysts, myself included, do not anticipate an interest rate cut this month.  After the September meeting of the Governing Council, the conditional and unlimited elements of the proposed OTM program were fleshed out.  Spain and Greece are balking at the required submission to macroeconomic reforms, yet the past month has seen investors give the benefit of the doubt to the likelihood that a bond buying program will be started before it’s too late to save the monetary union.   Since the September press conference, peripheral bond yields have declined in absolute terms and relative to German bund yields.  The euro has strengthened slightly more than 2.0% against the dollar and gained ground on its crosses.  Share prices have appreciated.

In September, ECB staffing forecasts were updated.  The projected a range of GDP growth next year that’s centered on 0.5%, which is an improvement on the recession now under way and in all likelihood overly optimistic.  Markets learned that German representatives on the Council voted against the OTM.  ECB Pdt Draghi also conveyed the message that monetary policy is not being transmitted evenly to all member countries.  Until the mechanism is repaired through non-standard measures, conventional tools like a cut in the 0.75% refinancing rate will be ineffective for all but the healthiest economies in the union.  Also, officials would want to cut the marginal lending rate and deposit rate, which flank the refinancing rate, at the same time, but that would entail accepting a negative deposit rate instead of its present level of zero.  That’s would be a big change, and officials are still exploring its merits and pitfalls.

It’s possible that modifications in the array of unconventional tools will be announced.  The one most speculated would be to undertake a third LTRO, but Draghi comments about that option have appeared to dampen its likelihood.  Euroland is eventually going to need more monetary support down the road, nonetheless, and investors should not be surprised if some kind of change occurs this month in the terms of its unconventional facilities.  OTM will be aborted unless fiscal policy becomes more restrictive in the peripheral economies.  There is less financial market strain than a month or two ago, but the regional economy remains in considerable distress.

The manufacturing and service-sector purchasing managers indices were both 46.1 in September, and the retail PMI was 47.1 that month.  Real GDP ticked 0.1% higher at an annualized rate in the first quarter of 2012 and then contracted at a 0.7% pace in 2Q.  These PMI results imply another contraction last quarter of at least the magnitude seen in 2Q and possibly a touch more.  Unemployment is 11.4%, over three percentage points higher than in the United States, and economic sentiment fell significantly over the third quarter, reaching a September reading of 85.0 versus 86.1 in August and 89.9 in June.  Exports are floundering, but the current account surplus is bigger.  Such averaged 0.7% of GDP over the first seven months of 2012, but the monthly average in June-August of EUR 11.4 billion was over 50% greater than the monthly average in January-April.

CPI inflation has not declined as much as forecasters were expecting.  The preliminary CPI in September accelerated to a 12-month increase of 2.7%.  Inflation has been hit by higher commodity prices and indirect tax increases to reduce fiscal deficits.  Labor costs remain subdued, posting an on-year increase of 1.6% in the second quarter.  Weak growth in money and credit point to lower inflation than now in the medium term.  That said, the hawkish members on the Governing Council will be anxious to avoid the juxtaposition of inflation well above target and sending signals to the market that are more dovish than markets expect to hear.  One way to underscore anti-inflationary credentials is to underscore that in no way will OTM be employed without full compliance of the receiving governments with programs of structural reform and deficit reduction

The ECB decision will be announced at 11:45 GMT on Thursday and be followed by a press conference at 12:30 GMT.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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