ECB Teases the Markets

• ECB disappoints, cutting refit rate 25bps to 1.25%
• Moderate further reduction in interest rates likely
• They will announce non-standard measures in May

The ECB failed to live up to expectations this morning and decided to reduce their targeted interest rates by only 25 basis points. There was some dissent, however, with some members preferring to deliver a larger punch this month. Before the meeting, there was a broad expectation that the ECB would likely lower their deposit rate by 25 basis points (to 0.25%), but would reduce their main policy rate by 50 basis points (to 1.00%). As well, there was a strong expectation that they would announce some non-standard measures to possibly include quantitative easing.

While they did disappoint, there were important developments for the future direction of Eurozone monetary policy. On interest rates, comments by President Trichet in the press conference following the decision made pretty clear that they are unlikely to reduce the deposit rate further from its current 0.25% level, but that the main refi rate is likely to still be lowered. Although he provided no indication of exactly how low this might be, we continue to think a base of 0.50% is possible. While the ECB sees headline consumer inflation averaging 1.0% in 2010, we see a strong chance inflation will be much weaker than this and that the economy will continue to contract into the first quarter of 2010. However, there will be little in the next few months that might sway the Governing Council's current expectations so they will likely be slow in delivering further cuts. We expect a 25bps reduction in May, with a further 50bps of easing possible by the fourth quarter of 2009.

President Trichet also precommited to announcing nonstandard measures at the next meeting. However, he would provide no details or context as to what may be included, or even clarify whether they would simply announce or actually begin these measures next month. We think it is very likely the ECB will extend to 12 months their current provision of unlimited credit of up to a six month maturity to the banking sector. We do not believe this will increase the supply of credit getting into the private sector, though. It also seems likely the ECB will move to begin buying some form of private debt. With the vast majority of corporate financing in the Eurozone taking the form of loans, rather than bonds and other capital market instruments, we think purchasing bank debt would stand the best chance to at least provide additional financing to the banking sector, which can then flow into the rest of the economy. This would also avoid wading into a politically more difficult question in the Eurozone of how to distribute purchases across other non-financial private sector debt.

Similarly, while the purchase of sovereign debt is possible, it does not seem likely at this time. The hurdles of coordinating such purchases across many member countries remain to be resolved. However, if it does occur, the plan would likely be based on an equitable distribution of purchases of all member debt, rather than a concentration on member debt which has seen the most stress. In our opinion, these purchases would stand the best chance to ease borrowing costs and provide more stimulus to the economy in a broad fashion than any other possibility reportedly under consideration, but unfortunately, the structure of the Eurozone limits this policy tool. All told, we believe the ECB is likely to reduce the main refi rate by 0.25% at their May 7th meeting, in addition to extending terms on ECB loans to the banking sector and begin to purchase private-sector debt.

ECB Press Conference Dissection (pdf)

TD Bank Financial Group

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