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ECB holds main policy rate at 1.5%; no new liquidity measures; inflation risks now broadly balanced

September 9, 2011

The ECB held the main refinancing rate at 1.50% as expected and changed key language in the policy statement related to growth and inflation risks to signal a more neutral bias — the monetary policy stance is still viewed as “accommodative” and there was no signal of a near-term reversal of July’s rate hike. No new liquidity measures were announced for banks although the ECB acknowledged that “some financing conditions have tightened” and President Trichet signaled readiness to act using non-standard or standard measures. The main downside risk to growth now firmly stems from tensions in financial markets that could spill over and affect activity in the real economy.

The change in the ECB’s view towards growth and inflation risks this month has effectively removed the chance of another rate hike this year and raised the prospect of a rate cut in coming months, which has supported Bunds and 3m Euribor futures across the curve and weighed on the euro. The yield on the German 10yr fell 8bps during the ECB press conference to touch a new crisis low of 1.821%, down 8bps from Wednesday.

The risks to the Eurozone economic growth outlook are now “on the downside” for the first time since February, rather than “broadly balanced.” More intense downside risks stem primarily from “ongoing tensions in some segments of the financial markets in the euro area and at the global level,” which have the potential to negatively affect the real Eurozone economy. Uncertainty remains “particularly high” and other downside risks continue to emanate from the chances of “further increases in energy prices, protectionist pressures and the possibility of a disorderly correction of global imbalances.” The Council did not list any upside risks to growth. Still, they do not expect a Eurozone or global recession and project further modest growth to be underpinned by global economic activity, the accommodative monetary policy stance and non-standard measures which are supporting the banking sector.

Although the Governing Council does not produce its own growth projections, their decisions are informed by their staffs’ forecasts, which were lowered sharply for both 2011 and 2012 (see table below) versus the last set of projections in June. The midpoint growth forecast for 2011 is now 1.6% (1.4-1.8%), down from 1.9% projected in June. Growth in 2012 is expected in a weaker range of 0.4 to 2.2% (midpoint: 1.3%) versus 0.6-2.8% (1.7%) previously.

On inflation, the Council now views the risks to the inflation outlook as “broadly balanced,” rather than “on the upside” as was the case in all of the introductory statements from March. This is a crucial development and effectively removes the chance of another 2011 rate hike and could pave the way for a rate cut, amid further deterioration in financial stability and economic activity that could weigh more heavily on the inflation outlook. There was no reference in the policy statement to preventing second round effects on prices and wages, and the Council removed the reference to upward price pressures being visible at early stages of the production process. The main change to the constellation of inflation risks was the introduction of the downside risk stemming from the chances that economic growth proves weaker than expected. Upside risks were unchanged and relate to the chances of higher than expected increases in commodity prices, as well as increases in taxes or government-related prices amid fiscal consolidation.

Although the ECB has now taken a neutral stance on inflation risks, the staff inflation projections were little changed from June. HICP inflation is still expected to be in a range of 2.5-2.7% in 2011, while the 2012 projected range was narrowed only marginally to 1.2-2.2% from 1.1-2.3% projected in June.

The new Governing Council view on the risks to growth and inflation outlined in the policy statement have effectively removed the chance of another 2011 rate hike, leaving the Governing Council unofficially on pause in an environment of “particularly heightened uncertainty.” President Trichet said that the decision today on interest rates was unanimous, but he would not disclose whether the Council had discussed a rate cut. He stressed that they “stand ready to do whatever is necessary” on either standard or non-standard measures. He ignored a question about the possibility of a joint-G7 central bank action, thus he did not rule it out.

The ECB’s main tools to counter the effects of tighter bank funding conditions and tensions in bond markets remain their provision of unlimited liquidity to banks and their bond purchases through the SMP, although a cut in the deposit rate is also possible to put downward pressure on short-term rates. If financial conditions deteriorate further, the ECB could introduce more long-term, emergency liquidity operations, building upon the 6-month operation that was conducted on August 10 after the last Governing Council meeting. Meanwhile the ECB is likely to remain active in the secondary sovereign debt markets through the SMP, although as usual, President Trichet would not give any details about their plans and merely outlined the weekly amounts of bonds purchased in recent weeks. It is still the working assumption of the Council according to Pres. Trichet that the Eurozone governments will rapidly approve and implement all measures agreed at the leaders’ meeting of July 21, including allowing the EFSF to purchase bonds in the secondary market. He stuck to the ECB line that the programme is necessary to smooth the transmission of ECB monetary policy throughout the system, and that this became necessary because governments behaved irresponsibly. In terms of the path for the main refinancing rate, the ECB has taken a step toward a stance in which it could justify a cut in coming months if recession risks intensify.

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