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The European Central Bank has announced that it is withdrawing some of its emergency measures as the 16-nation economy began to grow in the third quarter and conditions in the region's financial system showed notable improvements, suggesting that worst of the crisis is behind now. However, the central bank is unlikely to raise interest rates anytime soon. The central bank has stressed that its liquidity support remains substantial and indicated that its exit strategy will be gradual and timely.
In his introductory statement after the central bank left its key interest rate unchanged at a record low of 1% for a seventh straight month on Thursday, ECB President Jean-Claude Trichet said the 12-month unlimited loan offer for banks, to be alloted on December 16, would be the last. Unlike it did in September, he said, the interest rate on the December operation will be the average of the minimum bid rates on the ECB's main refinancing operations, over the life of the 12-month tender.
The decision to offer the 12-month loans on the ECB's key rate rather than setting a fixed rate of 1% implies that any increase in the benchmark will also affect banks' funding costs. "By structuring the operation in this way, the ECB has made sure that future movements in interest rates will be reflected in banks' funding costs," said Colin Ellis, European economist at Daiwa Securities SMBC Europe Ltd. As regards longer-term refinancing operations in the first quarter of 2010, ECB policymakers decided to carry out the last six-month longer-term refinancing operation on March 31, 2010. "This operation will be carried out using a full allotment fixed rate tender procedure, as will the regular monthly three-month longer-term refinancing operations already announced for the first quarter of 2010," Trichet said.
"The gentle exit has begun," ING senior economist Carsten Brzeski said. "It will be very gentle in the beginning but eventually it will end in rate hikes," he added.
Moreover, the ECB chief said the improved conditions in financial markets have indicated that not all of the central bank's liquidity measures are needed to the same extent as in the past. At the same time, the central bank will continue its enhanced credit support to the banking system, while taking into account the ongoing improvement in financial market conditions and avoiding distortions associated with maintaining non-standard measures for too long.
"These decisions represent a careful balancing act, which should allow the ECB to limit the scope for speculative carry trades without putting the weaker banks at undue risk, and allow the ECB to shift the weight of the liquidity to shorter term operations, so as to be able to drain liquidity more quickly if and when appropriate," said Marco Annunziata, chief economist at UniCredit Group. "We stick to our call for a Refi rate on hold throughout 2010."
Looking ahead, Trichet said the Governing Council will gradually phase out, at the appropriate time, the extraordinary liquidity measures that are not needed to the same extent as in the past. In order to counter effectively any threat to price stability over the medium to longer term, the ECB will absorb the liquidity provided when necessary.
Trichet reiterated that the current interest rates remain appropriate. Repeating his statement from last month's introductory statement, he said, "The Governing Council expects the euro area economy to grow at a moderate pace in 2010, recognizing that the recovery process is likely to be uneven and that the outlook remains subject to high uncertainty."
The ECB staff has become more optimistic on the economic outlook than three months ago. Unveiling the latest ECB staff projections, Trichet said the Eurozone economy may contract between 4.1% to 3.9% in 2009 before growing 0.1% to 1.5% in 2010 and 0.2% to 2.2% in 2011. In September, the ECB staff had forecast 0.2% growth for 2010 after a 4.1% contraction this year. He added that risks to this outlook was broadly balanced.
Yesterday, a first estimate from the Eurozone showed that the euro area economy expanded 0.4% in the third quarter after contractions in past five quarters.
"The ECB remains cautious about Eurozone growth prospects despite the region's return to expansion in the third quarter and continuing expansion in the fourth quarter," IHS Global Insight Chief European and U.K. Economist Howard Archer said. "The ECB suspects that recovery in 2010 will be moderate and uneven, reflecting the fact that a number of the measures currently supporting Eurozone growth will be temporary, most notably inventory developments." The ECB gives the impression that interest rates are likely to stay down at 1.00% until at least late 2010, according to Archer.
On prices, the December 2009 Eurosystem staff projections foresee annual HICP inflation of 0.3% in 2009, between 0.9% and 1.7% in 2010, and between 0.8% and 2.0% in 2011. That compares to a September forecast of 0.4% for 2009 and 1.2% for 2010. The central bank targets to keep inflation below, but close to 2% over the medium term.
"From this starting point they will not have to revise their inflation expectations much upward before they can defend moving away from the current record low refinancing rate," Danske Bank senior economist Frank Øland Hansen said. "We stick to our expectations that the ECB will begin its hiking cycle next summer."
While headline inflation is forecast to increase over the coming months, core inflation is subjected to significant downward pressures. Under these conditions the ECB is not expected to raise the refi rate from an historical low of 1% until the second half of 2011, BNP Paribas economist Clemente De Lucia said.
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