Reflections on the ECB: Part 1

The ECB left rates unchanged at their meeting yesterday, but shifted their language to focus more on downside risks, such that a July cut cannot be excluded if data continue to be soft.

Specifically, the ECB stated that if economic growth remains weak, then heightened uncertainty, weighing on confidence, will give rise to increased downside risks. In previous months they have just stated that there was uncertainty and that there were downside risks.

Mr Draghi also admitted that the decision to keep rates unchanged was not unanimous, with some wanting to cut rates yesterday.

The broad consensus to leave rates where they are was consistent with the decision to run with an unchanged economic forecast. Nevertheless the Governing Council is clearly aware that recent soft data, and especially the Purchasing Manager and sentiment surveys, point to further downside risks, and this is why downside risks had been emphasized.

We may reasonably assume that if there is a change in official growth forecasts so the ECB will change policy and Mr Draghi emphasized that the Governing Council stands ready to act.

Apart from the clear linkage between explicit growth forecasts and policy rates, it is also apparent that the ECB is biding its time to put pressure on politicians to act. The official line adopted by Mr Draghi is that there is no cosy connection between ECB actions and politicians delivering, but he also stated that “some of the problems in the euro area have nothing to do with monetary policy” and that he did not think it would be “right for monetary policy to fill other institutions’ ‘lack of action’”.

Mr Draghi and the ECB do however remain optimistic that politicians will edge gradually towards a more federal agenda for Euroland and he took the opportunity to restate that observers underestimate the strength of the political commitment to the monetary union and also underestimate the many benefits the euro has brought.

We may conclude that whilst the ECB took no action on rates yesterday it is concerned about dysfunctional and fragmented markets and will continue watching the data closely.

Underpinning the ECB’s unchanged economic forecasts, and this is acknowledged by Mr Draghi, are the assumptions that financial tensions will abate, and world demand will remain buoyant.

If these assumptions disappoint, we can expect early action to cut rates by the ECB, and there could also be further quantitative easing.

For the time being, the only practical decision or step taken by the ECB is to extend until early next year the fixed rate, full allotments of its main refinancing operations (MROs) and long term refinancing operations (LTROs), and this was widely expected by market participants.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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