Interest rate cut on the cards at ECB

Posted on July 4, 2012

Might the European Central Bank spring another July surprise on markets? While the consensus among central bank watchers is that an interest rate cut is on the cards from the meeting of its governing council on Thursday, the ECB has form when it comes to defying expectations at this time of year.

Twelve months ago, and citing inflation risks, the bank pressed ahead with a rate rise, emphasising its divergence from the views of the US Federal Reserve and the Bank of England. In July 2008, between the crises at Bear Stearns and Lehman Brothers, the ECB was again trying to curb inflation when it raised interest rates to a seven-year high.

    Today, inflation is not a particular worry for the eurozone – but growth is. A host of economic data have shown weakness for which a rate cut would be an orthodox answer. On Wednesday a survey of purchasing managers suggested that the eurozone’s services and manufacturing sectors have just had their strongest quarterly contractions for three years.

    Policy-makers have paved the way for a cut to an extent that it would constitute “a significant negative market surprise” if rates were left unchanged, Jens Sondergaard, senior European economist at Nomura, said this week, and a number of analysts predict a larger cut of 50bp.

    But a minority of analysts believes “no change” is possible – and support for such a stance has come from Christine Lagarde, the International Monetary Fund’s managing director. Suggesting the ECB dig into another part of its policy toolbox, Ms Lagarde said this week more asset purchases by the central bank might be more “judicious” than a rate cut, which would be a boon to countries such as Spain but would be too accommodative for Germany.

    For the ECB’s governing council under Mario Draghi, bank president, asset purchases – such as buying the bonds of countries struggling with high borrowing costs – are contentious. Many at the ECB believe it is not its role to solve what is in effect a political problem. In an interview on Wednesday with the Dutch weekly Elsevier, Klaas Knot, head of the Dutch central bank, affirmed that view, saying: “If someone must help southern Europe, let it be other governments, not the ECB.”

    The ECB’s sovereign bond buying programme, officially the “securities market programme”, has racked up more than €200bn of buying since 2010 but was last used in March. Mr Knot said the programme “is in a deep sleep, and it will remain there”.

    Ken Wattret of BNP Paribas says that, among the ECB’s “unconventional measures”, giving more cheap long-term loans – such as those dished out in December and February to more than 500 eurozone banks – is a more palatable option than restarting the SMP but says the governing council probably has “limited appetite” at this point.

    Benoît Cœuré, an ECB executive board member, told the FT last month that the full consequences of the €1tn of loans so far have not been seen, suggesting another such operation was unlikely at this stage.

    Might the ECB offer other “non-standard” help for struggling banks? Last month the central bank loosened rules for accepting asset-backed securities as collateral, interpreted as a helping hand for Spanish banks. It could offer more in this line, and lower “haircuts” on ECB financing operations would improve sentiment in the market, says Nomura.

    However, such a move would add risks to the ECB balance sheet. Indeed this week the ECB moved to tighten rules on another subset of collateral – bank bonds with sovereign guarantees – in a show of its unease at the accumulating risk.

    Mr Wattret says the ECB is very likely to deliver lower policy rates but will probably favour cutting by 25bp. “The faster the ECB exhausts its conventional ammunition, the sooner the pressure will build for more radical, Fed-style measures,” he argues. “The ECB will presumably be keen to avoid delivering all the ‘easy stuff’ and opening the door to a barrage of questions about what unconventional measures they would be willing to consider.”

    Additional reporting by Matt Steinglass in Amsterdam

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