ECB Preview: Announcing Non-Standard Measures

• We expect the ECB to cut the refinancing rate by 25bp to 1.0%. This is likely to be the end of this cutting cycle as the governing council seems reluctant to go below 1%.
• The deposit rate is expected to stay unchanged at 0.25%. After this meeting, rates are likely to be kept unchanged for a long time before the ECB starts hiking.
• Trichet has promised to announce a package of non-standard measures that the ECB stands ready to implement. This package could include a 12-month auction, purchase of quantitative paper and changes in collateral criteria.
• There is a small risk that the ECB will use the last month's more positive developments in Euroland confidence and Asian hard data to take a wait-and-see stance. The risk is thus for a disappointment and higher yields.

The end of the cutting cycle

We expect the ECB to cut the refinancing rate by 25bp to 1% at its next meeting on Thursday and that this will be the end of the cutting cycle. At the last meeting, the ECB disappointed the market when it only delivered a 25bp rate cut against widespread expectations of a 50bp cut. This is likely to have been a compromise. At the press conference Trichet kept the door open for further rate cuts and the tone of the speeches given subsequently is in line with our expectation that another 25bp cut is due, but not more than that. There have been plenty of signals from members of the governing council that they are reluctant to go below 1%, although it has never been fully ruled out.

Since the last meeting of the governing council, global data have improved and Asian data in particular have signalled the possibility of a rebound. Euroland data have become less negative too. Most importantly, confidence indicators have improved and last week's bank lending survey showed that credit tightening is slowing. There is a small risk that the ECB will use these positive developments to take a wait-and-see stance – it could even have ongoing discussions about the risk of over-stimulating the economy in the medium term. On the other hand, the economy is still in a very bad state as emphasised by the European Commission's spring forecast, which projected a 4.0% decline in Euroland GDP in 2009. Indeed, a lot of hard data are still in virtual freefall. Certainly the council members are not carried away by the improved sentiment in April. Mr Weber, president of the German Bundesbank, said in a speech on Monday that he did not expect the German economy to return to growth before the second half of 2010. We thus stick to our expectation that the ECB will cut the refinancing rate by 25bp, which is in line with market expectations (in a Reuters poll all 79 participants expect a 25bp rate cut).

We expect that the ECB will leave the deposit rate unchanged at 0.25%. Some members of the governing council have expressed unwillingness to go to zero interest rates and there may also be practical reasons to keep a positive deposit rate. Nevertheless it cannot be fully ruled out that the ECB will lower the deposit rate to zero. The deposit rate has become more important since the ECB switched to full allotment at a fixed rate on the weekly auctions as it means overnight rates have been falling closer to the deposit rate rather than staying around the refinancing rate.

The policy rates are projected to be kept unchanged for a long time. We do not see a rate increase within 12 months. Nevertheless, the ECB will be careful to avoid keeping the policy rates low for too long.

A package of non-standard measures

Trichet has promised that at the press conference after this council meeting he will announce a package of non-standard measures that the ECB stands ready to implement. These measures are likely to be focused on easing conditions for banks as banks account for 70% of Euroland lending.

One measure that is likely to be in the package is an expansion of the lending to banks with a 12-month auction (currently the longest is six months). In addition, the package could include some form of quantitative easing. We believe that the ECB will prefer to buy corporate paper rather than government bonds. This will help to bring spreads between rates on corporate papers and government bonds down. We do not know how the ECB will decide what to buy. It will buy in the secondary market (to avoid claims of subsidising specific companies) and will probably prefer papers with a relatively short duration. It is likely that it will buy papers with a relatively low rating as this is where it can have the biggest market impact. On the other hand, we doubt that the ECB is keen to start buying junk bonds. The corporate debt markets vary significantly from country to country with the French market being the largest by far. How the ECB may take account of this will be interesting to see.

The ECB has indicated that it is not pleased with the quality of the collateral that it is receiving. It is possible that it will use this opportunity to modify the collateral requirements.

There is a risk that the ECB will announce the non-standard measures that it has ready to use, but that it will wait and see before it implements them. If hard data then improves, there is a risk that the tools will never get out of the toolbox.

Recent comments from ECB members

Axel A. Weber (Germany), May 4

On the economy: "At the moment, I do not expect to see positive (GDP) growth rates in Germany before the second half of next year," he said. "We should not assume that the rapid weakening of the business cycle will be followed by an equally powerful recovery"

Lucas Papademos (Vice President), May 4

On exit strategy: "We should do what is needed to support recovery, but also pursue credible exit strategy when conditions normalise"

Juergen Stark (Executive board), April 29

On interest rates and non-standard measures: "We will decide about the modest remaining room to manoeuvre in rate policy on May 7. At the same time we will decide on non-standard measures to employ once our interest rate lower limit is reached"

Lorenzo Bini Smaghi (Executive board), April 27

On non-standard measures: "When deciding on (non-standard measures), monetary policymakers have to think ahead and ask themselves: 'We can get in, but how do we get out?'. They need to consider carefully the timing of their withdrawal of such monetary measures -- for there are risks in doing it too early, and there are risks in leaving too late"

Ewald Nowotny (Austria), April 27

On interest rates and non-standard measures: "We will keep the interest rate very low for as long a time as is required and stand ready to use unconventional measures of quantitative easing to assure European firms and consumers access to credit at appropriate conditions"

Axel A. Weber (Germany), April 22

On interest rates: "One of the lessons of the past has been that leaving rates too low for too long can contribute to macroeconomic and financial imbalances down the road"

Ewald Nowotny (Austria), April 20

On interest rates "I myself am sceptical of zero rates. One has to look at the whole interest rate picture, not only at the ECB main rate. And here there is the 1 percent limit, one that, in my opinion, should not be crossed"

Danske Bank
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