ECB to Drain Liquidity Gradually

The upcoming ECB meeting is the focus of the week as the President Trichet has mentioned several times that more detailed money market measures will be announced at the March meeting. Given the negative impacts of Greece's sovereign crisis and sluggish economic data released since the previous meeting, we believe the measures will not be drastic and the policy rate will stay unchanged at 1%. ECB staff will also publish a new set of economic forecasts. Again, we expect only modest changes from previous projections.

In December, the ECB made several announcements regarding refinancing operations. The main refinancing operations (MROs) with full allotment will last as long as it's needed and at least until the third maintenance period of 2010 ends on 13 April; the rate in the last 12-month longer-term refinancing operation (LTRO) was fixed at the average minimum bid rate of the MROs over the life of this operation. At the same time, the last 6-month LTRO will be carried out on 31 March 2010 using a full allotment fixed rate tender procedure while the same approach was also used in the regular monthly 3-month LTRO.

Several changes will be announced in the press conference on Thursday as the Governing Council seeks to smooth out the liquidity effect of the 12-month LTRO maturing during 2H10.

We expect the ECB will announce the 3-month and the last 6-month tender will be offered at a tracker rate, same as the case of the 12-month tender offered in December. At the same time, the central bank will continue to produce unlimited funding, but via MRO with shorter maturity (eg: 1 month or 1 week), at least until July 1 when the first 12-month LTRO with a volume of 442B euro expires. Moreover, so as to normalize the money market operation, the ECB will likely re-introduce auction for LTRO. This, together with reducing maturity of the funding operations, money market rate should increase. The theme of the measures will be that the ECB would like to ensure sufficient liquidity is in the system while excessive money will be drained gradually.

ECB staff's economic projection should not have changed materially, although there may be modest upward revisions. In December, Eurosystem staff projected annual real GDP growth of between -4.1% and -3.9% in 2009, between +0.1% and +1.5% in 2010, and between +0.2% and +2.2% in 2011. Recent economic indicators suggested that growth in the Eurozone is losing steam. Together with uncertainty in Greece' deficit issue and potential contagion in peripheral European economies, the ECB will remain cautious. Inflation outlook remains benign. In December, Eurosystem staff projections foresaw 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. We expect little change on these estimates.