ECB a Little More Optimistic but Rate Increases Remain Off the Agenda

• ECB upgrades economic forecasts, but Trichet remains 'cautious and prudent'
• ECB still seeing a very different world than US Federal Reserve or Bank of Japan
• First interest rate increase still seems a very long distance away; perhaps late 2011 or early 2012
• Extensions of liquidity support are broadly as expected but underline continuing problems in peripheral economies
• ECB may be divided about how much support to give to periphery
• Mr Trichet does little to ease pressure on Irish borrowing costs. Does this mean a tougher budget?

There were no fireworks at today's European Central Bank press conference, but there were some hints at rumblings beneath the surface. ECB president Jean Claude Trichet continued to signal that we remain some considerable distance from any prospect of a rise in ECB policy rates. He also indicated that the ECB will continue to supply ample liquidity to Eurozone banks at least until the end of the first quarter of 2010. Implicit in this commitment is recognition that while there has been some improvement in the functioning of financial markets, considerable difficulties remain particularly for banks in peripheral countries. Finally, the ECB also upgraded its growth and inflation forecasts. This would suggest that unlike the US Federal Reserve, the ECB is very far from a position in which it feels it may need to consider further action to support economic activity.

In stark contrast to a number of other central banks, the European Central Bank appears comfortable that the Eurozone economy is set to remain on an improving trajectory. New economic projections entail a significant upgrading of its forecast for 2010 GDP growth from 1.0% in its June projections to 1.6% today. In large part, this reflects what Mr Trichet acknowledged as 'stronger than expected' recent data. A positive carryover effect from 2010 is largely responsible for a modest upward revision to the ECB's 2011 GDP growth forecast to 1.4% from the previous 1.2% estimate. The fact that growth in 2011 is expected to be weaker than in 2010 emphasises that the ECB expects the recovery will remain modest, Mr Trichet also noted that the risks to 'this improved economic outlook are slightly tilted to the downside'. To underline this message Mr Trichet said the ECB would remain 'prudent and cautious'. So, the ECB is not blind to concerns emerging elsewhere about a faltering recovery but, as has been the case in recent months, its assessment is still reasonably confident about growth prospects. The ECB will have drawn comfort from today's detailed Eurozone GDP data that show both consumer spending and investment making significant contributions to the strong expansion in the second quarter. Coupled with an upward revision to the first quarter GDP growth figure, recent statistical evidence is encouraging. However, questions remain both about the capacity of the Eurozone to decouple from softer growth elsewhere and also about the increasing impact austerity programmes and elevated funding costs will have on a number of peripheral Eurozone economies in late 2010 and through 2011.

The ECB also revised its forecasts for inflation today, but Mr Trichet was at pains to emphasise that the outlook for inflation is still completely consistent with the ECB's measure of price stability. So, there is no implicit treat of future interest rate increases. Inflation forecasts for 2010 and 2011 were each revised up by 0.1% to 1.6% and 1.7% respectively. While the ECB also noted that the risks to the inflation outlook were tilted to the upside - a development that might be ominous for interest rates policy in other circumstances, Mr Trichet repeatedly said that the outlook for inflation remained positive to reinforce the message that there is no risk of a rise in policy rates anytime soon.

Mr Trichet also outlined measures today to extend the time frame of exceptional liquidity support to the Eurozone financial system. He said one week and one month refinancing operations would continue with full allotment (i.e. all demands for funds being met) at a fixed rate at least until mid January 'for as long as necessary'. He also indicated that 3 month liquidity would be provided at end October, November and December 2010 on the same full allotment basis. However, there was a slight change in the rate applicable. It would still be fixed, but at the average rate of the MROs over the lifetime of each 3 month LTRO. Mr. Trichet called the change completely technical in nature, but it also means that the ECB in theory is completely free to redesign its policy from early 2011 onwards, including eventual increases in its refi-rate. However, we don't think this will actually happen.

Three additional fine-tuning operations offering twice 6-day and once 13 day liquidity on the same terms would be carried out on 30 September, on 11 November and 23 December to meet any liquidity needs arising from the maturity of current 6 and 12 month offerings at end September, mid November and 23rd December. These operations will be conducted under the same procedure as the MRO operations (fixed rate/full allotment). Similar fine-tuning operations were used when at the end of June 1-year LTRO matured.

This approach was broadly as expected but, at the margin, the "technical" change to the procedure for the 3-month LTRO means that the possibility of a new, extra step in the exit policy may occur at the beginning of Q1 2011, whereas if the 3-month LTRO was conducted under the fixed, fixed variant, it would have been difficult to take such a step before the last three month LTRO matured at the end of March. This might have been the concession Mr. Trichet had to make to the hawks inside the council to get the consensus on the policy. Note that while ECB Weber suggested a prolongation of the 3-month LTRO at full allotment, he limited it to the three month operation in September, that would carry the unlimited liquidity provision over the year end.

Despite these comments, the ECB is still anxious to prevent any fears emerging that Eurozone banks could face increased funding difficulties in coming months.

When asked at today's press conference whether the measures he had announced were intended to deal with normal year end pressures, Mr Trichet replied that had this been the case, shorter term operations would have been introduced. So, today's announcement reflects continuing concerns about the health of financial institutions in a number of countries, most likely Greece, Spain, Portugal and Ireland, rather than system-wide difficulties. Mr Trichet's acknowledgement that whereas today's decisions on interest rate policy had been arrived at unanimously, decisions on liquidity had emerged through consensus is also worthy of comment. It hints at divisions within the ECB Governing Council on the appropriateness of support mechanisms whose importance varies hugely from country to country.

Mr Trichet's reluctance to answer questions on peripheral bond spreads may also hint at significant differences of opinion within the ranks of the Governing Council as to how to respond to marked national divergences in financial (and economic health) at present. When asked about the persistence of wide spreads across Eurozone Government bonds, Mr Trichet side-stepped the question by responding that the ECB 'continues to adjust what we do to ensure the functioning of the market'.

From what the ECB has said and done of late, it would appear that serious doubts about the merits of supporting particular countries bonds have minimised the use of this policy tool and in its place the ECB may have agreed to extend unlimited support for Eurozone banks rather longer than some Governing Council members would like. So, the ECB is willing to act as a lender of last resort to Eurozone banks but not to European Governments.

In practice, peripheral Governments bonds may be supported through their purchase by commercial banks that use them as collateral in ECB refinancing operations. However, the perceived reluctance of the ECB to intervene in peripheral bond markets may maintain pressure on bond spreads in coming months. The associated increase in funding costs and the need to convince more sceptical international markets may require Governments to make somewhat larger budgetary adjustments and also threaten higher borrowing costs for some private sector borrowers in affected countries.