ECB Preview: No Rate Cuts Despite Inflation at 0%

We expect the ECB to keep the refinancing rate unchanged at 1.0%. The governing council seems reluctant to go below 1% even with inflation at 0% and falling. We expect the policy rates to be kept unchanged for the next 12 months.
ECB staff growth projections will be revised down to slightly below -4% for 2009, but might be revised slightly up for 2010. Inflation projections are likely to be almost unchanged, although a slight upward revision in 2010 is a possibility.
The focus will be on the press conference. We will get details about the purchase of covered bonds for possibly EUR 60bn. If the ECB announces a country distribution of the covered bond purchases, this could move cross-country interest rate spreads.
We do not expect that the ECB will announce additional measures or top up on already announced measures. Another month of positive developments in Euroland confidence and Asian hard data means that ECB's rhetoric will begin to focus more on exit strategy.

Policy rates to be kept unchanged for a long time

We expect the ECB to keep the refinancing rate unchanged at 1% at its next meeting on Thursday. Inflation is now at 0% and will fall to well below zero in the coming months before returning to positive territory in October or November. However, the ECB is not very concerned about the prospect of deflation this summer. It is to a large extent a mirror of last summer's inflation peak and in any case the ECB's governing council is firmly focused on the medium term. In the medium term inflation will be low, deflation is not much of a worry given that core inflation remains stable and there are an increasing number of signs of an economic rebound. Governing Council Vice President Lucas Papademos has recently acknowledged that there are signs of an earlier recovery than previously anticipated - possibly beginning before the end of 2009.

It could be argued that if a Taylor rule is applied interest rates should be taken to zero or lower. There have however been plenty of signals from members of the governing council that they are reluctant to go below 1%. We do not think that the ECB will do so unless the economic prospects deteriorate again and it starts to see a real risk of deflation.

We expect that the ECB will keep the marginal lending rate and the deposit rate unchanged too, i.e. keeping the symmetrical band. Some members of the governing council have expressed unwillingness to bring the deposit rate to zero and there may also be practical reasons to keep a positive deposit rate. The deposit rate has become more important after 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 hike within 12 months. Nevertheless, the ECB will be careful to avoid keeping the policy rates low for too long and when the economy starts to pick up we should watch out for signals of an early surprise move from the ECB.

Staff projections

ECB staff projections for growth will be revised down to slightly below -4% for 2009, but might be revised slightly up for 2010. The very downbeat projection for this year largely reflects that the decline in Q1 was steeper than anticipated (-2.5 % q/q). We expect the rhetoric on growth prospects to be more positive than previously. The possibility of a rebound beginning before the end of 2009 as Papademos recently acknowledged could well be mentioned. The possibility of a positive blip before getting sustained positive growth rates mid next year, as hinted by Weber, might not be included in the projections, although we see this as a rather feasible growth outcome.

The inflation projections are likely to be almost unchanged, although a slight upward revision in 2010 - reflecting the prospects of higher energy prices than previously anticipated - is a possibility.

How to purchase covered bonds

At last month press conference Trichet announced that the Eurosystem (ECB and the European central banks) will purchase euro-denominated covered bonds issued in the euro area for about EUR 60bn. The argument given by Trichet for buying covered bonds is that this is one of the segments of private securities that have been most affected by the financial turmoil. The purpose of such credit easing is to reduce the risk spread between those markets that are particularly impaired and those that are functioning better.

The asset purchases undertaken by both the Federal Reserve and the Bank of England are much more aggressive than the EUR 60bn announced by the ECB. Nevertheless, we do not expect the ECB to increase this amount. Last Friday Trichet confirmed that they expect to engage in a programme of around EUR 60bn. If financial market confidence continues to improve there is a tiny risk that the ECB will buy covered bonds for less than initially indicated, but this will not be announced on Thursday.

If the ECB announces a country distribution of the covered bond purchases, this could move cross-country interest rate spreads. Covered bonds are more widely used in Germany than in most other member states, and it will be particularly interesting to see how the ECB chooses to deal with this. The German Pfandbrief market amounts to a third of the total Euroland covered bond market while Spain accounts for almost 30% and France almost 15%. To achieve its aim the Eurosystem will have to buy significantly more in these markets than in those of other Euroland countries.

It should not be seen as a big issue whether the ECB sterilizes its credit easing or not. EUR 60bn only amounts to about 4% of the Eurosystem's current balance sheet and it is also a relatively modest amount relative to the EUR 600bn that the Eurosystem's balance sheet has already been expanded by since the financial turmoil broke out in July 2007. Trichet has however said that the Governing Council considers sterilization and the exit strategy absolutely essential to maintain the maximum amount of credibility in the medium and long term. Thus we would expect most of the credit easing to be sterilized.

We expect that the Eurosystem will begin the purchase of covered bonds within a month.

Recent comments from ECB Governing Council members

Jean C. Trichet (President), May 29

On credit easing: "We expect to engage in a programme of around 60 billion euros that targets an important segment of the private securities market which has been particularly affected by financial market turbulence"

Ewald Nowotny (Austria), May 26

On the need for further measures: "We assumed (at our May meeting) that the June projections would be worse and therefore already factored in a deep crisis. We think that the steps we have taken are adequate in the medium term. We see no need to change them."

Jose M. Gonzalez-Paramo (Executive board), May 25

On how soon after the June 4 meeting the ECB would start buying covered bonds: "It's most likely to be weeks"; "As soon as it is technically possible, the institutions have to prepare themselves to bid. It's purely a question of technical implementation, technical preparation."

Axel A. Weber (Germany), May 25

On the economy: "Recently, the signs of an easing in the downward trend are increasing both in the euro zone as well as Germany."

Lucas Papademos (Vice president), May 18

On the economy: "Our central scenario continues to be that the recovery of the European economy, and of the euro zone in particular, will gradually take place during next year, but recent evidence may be suggesting that it could come a little sooner... meaning towards the end of 2009."

Axel A. Weber (Germany), May 18

On the economy: "I don't expect sustained positive growth rates before the middle of next year, which does not rule out that there might be a positive blip in the meantime."

Danske Bank
http://www.danskebank.com/danskeresearch

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets´ research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.