ECB Suggests Enough Has Been Done

• Trichet suggests no near term policy changes, but won't entirely rule out further cuts
• Comments suggest ECB believes worst is over, turnaround will be slow
• ECB likely to remain on sidelines unless further 'shock' hits economy
• So, very likely that rates have bottomed even if first hike seems far away
• Slightly tougher line on inflation suggests ECB hawks still influential

The build up to today's monthly policy meeting of the Governing Council of the European Central Bank was considerably quieter than has been the norm of late. In part, this reflects the fact that the ECB's scope for further conventional policy changes has been almost depleted following 7 rate cuts since October. In any event, by indicating last month that policy rates were 'appropriate', Mr. Trichet effectively signalled that rates would not be cut in June. A lot of the potential for excitement this month was also removed by the pre-announcement of the decision to purchase covered bonds and to lengthen the maturity of the ECB's refinancing operations as far as 12 months. So, markets looked to today's ECB meeting largely for technical details as to how last month's 'unconventional' measures would operate in practice.

Markets were right not to anticipate fireworks from the ECB today. The broad thrust of Mr. Trichet's press conference suggests the ECB feels it has probably done enough in terms of policy support for the Eurozone economy. As a result, no further policy initiatives are envisaged for the foreseeable future. Mr. Trichet's reiteration today that the ECB feels its policy rates are 'appropriate' effectively rules out any policy shift for the next couple of months. However, by repeating that the ECB 'did not decide this is necessarily the lowest limit for rates' Mr Trichet highlights the ECB's awareness of continuing downside risks to the Eurozone economy. As we noted last month, we think the ECB wants markets to travel hopefully, holding on to a slight possibility of further rate cuts rather than arrive at the conclusion that the only way that rates can move is upwards.

The thrust of Mr. Trichet's comments on the economy today suggest the ECB now believes the worst is over even if its latest projections imply the downturn was a good deal more severe than the ECB previously thought. Mr. Trichet repeatedly emphasised that the pace of decline had eased of late and was likely to continue to do so in coming months. However, no dramatic turnaround is envisaged. Mr. Trichet said he remains 'very cautious on recovery'. This is reflected in the ECB's expectations that it will be the middle of next year before growth rates begin to turn positive.

Although the ECB feel that conditions may be stabilising, their new economic projections suggest that the year ahead will be quite difficult. Eurozone GDP is expected to shrink by 4.6 per cent in 2009, a 2 sharp percentage point deterioration compared to the 2.7% decline envisaged in the March projections. More ominously, the ECB envisages that a further contraction in activity is likely in 2010. Clearly, that points towards significant upward pressure on unemployment throughout the forecast period.

Economic conditions as depressed as those set out in today's ECB projections will clearly dampen inflation. In spite of the recent rise in oil prices, inflation is expected to remain subdued both this year and next as the impact of notably weaker activity and a stronger Euro is felt. The new ECB inflation projections are not dramatically changed from March with consumer prices expected to rise 0.3% in 2009 and by 1.0% in 2010. Although the numerical projections may be unchanged, there is also some hint of slightly more hawkish thinking on inflation at the ECB in today's comments.

The sharp drop in Eurozone inflation to zero last month increases the likelihood that inflation will turn significantly negative in the months ahead. It might be expected that the combination of very weak activity and negative 'headline' inflation rates could push prices even lower than is now envisaged. Against this, however, the main driver of the fall in headline inflation - energy costs have recently reversed course. It would seem that the ECB feels this turnaround in energy costs will prevent a lasting decline in inflation. Indeed, this change may have made it slightly more concerned about inflation prospects over the longer term. Certainly, one of the more notable changes in today's press statement from last month was the omission of the sentence 'moreover, signs of a more broad based reduction in inflationary pressures are increasingly emerging'. Does this suggest the hawkish wing of the ECB is revitalised?

Alongside these developments is a broader if still somewhat vague concern about a possible return to high inflation exemplified by recent comments from the German Chancellor, Angela Merkel. The risk that extraordinary policy stimulus will prompt an eventual inflation surge is becoming a focus for financial markets. Indeed, like the rise in 10-year break-even inflation rate indicates the increase in longer-term yields this year has been mainly driven by higher inflation expectations.

So, it may be that the ECB is subtly changing its commentary to ensure its credibility as an inflation fighter is beyond question. This debate about whether inflation will be too high or too low in coming years is likely to take many twists in the months ahead. With weak activity and low headline inflation on one side and, on the other, financial market's focus on how 'the day after tomorrow' might look, there is a prospect of increased volatility in long-term interest rates.

In summary, today's ECB meeting was a relatively dull affair. On the first anniversary of what was probably the last real 'shock' announcement from a Governing Council Meeting - when Mr. Trichet presignalled the ill-judged rate increase of July 2008, it is scarcely surprising that the ECB might prefer to remain out of the spotlight. A wait and see stance on policy seems appropriate at present. Even if conditions are weak, there are welcome signs of a stabilisation after the freefall of late 2008/early 2009. A lot has been done in terms of policy support and it will take up to a year before the substantive impact of these actions feeds into healthier activity. We continue to hold the view that ECB policy rates have bottomed. Markets may soon begin to debate when the first rate increases might arrive although that seems more likely to be an issue for the summer of 2010 than that of 2009

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