EMU: ECB Announcement

Thu Dec 03 06:45:00 CST 2015

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In line with expectations, December's ECB meeting saw no change in the benchmark refi rate (0.05 percent). However, the central bank did deliver a 10 basis point cut to minus 0.30 percent in the rate levied on banks' deposits in the current account. The marginal lending rate was held steady at 0.20 percent.

Financial markets had already effectively priced in a reduction in the deposit rate of around 15 basis points so, if welcome, today's announcement was still viewed as slightly inadequate. Hence bond prices initially slipped and European equities gave back earlier gains while the EUR clawed back some previous lost ground. Getting agreement with the more hawkish Council members, notably Germany, for a larger cut was always going to be difficult. As it is, apart from increasing costs in the banking sector, it is difficult to see a 10 basis point ease having much of an economic impact. The banks should be encouraged to lend more but, realistically, for some time now sluggish borrowing has had more to do with a lack of demand than inadequate would-be supply.

More important anyway was always going to be what the ECB would do with its QE programme and here, despite all the hype, the news was clearly at the less aggressive end of market expectations. In particular, there will be no increase in the E60 billion/month asset purchase programme (APP). Disappointment here may be tempered somewhat by a decision to extend the earliest cut-off date from September 2016 to March 2017 but with the same open-ended caveat about economic conditions still applicable, the formal extension could be irrelevant anyway.

Of potentially some significance, the ECB will support its balance sheet by reinvesting principal payments on maturing securities held under the APP. This at least suggests that liquidity will be maintained at higher levels than would have previously been the case. The APP itself will be expanded to include regional and local government debt but some will have hoped for a more broad-based expansion. Lastly, ECB Chief Draghi also indicated that the main refi operations will continue to follow the existing practice of fixed rate and full allocation tenders.

Like many central banks, the ECB justified today's actions by reference to a slightly more downbeat set of inflation forecasts. Versus the September projections, these put HICP inflation unchanged at 0.1 percent this year but down a tick in both 2016 and 2017 at 1.0 percent and 1.7 percent respectively. Lower prices were accompanied by just a minimally stronger revised growth outlook which has the Eurozone economy expanding 1.5 percent in 2015 (versus 1.4 percent last time), 1.7 percent next year (1.7 percent) and 1.9 percent in 2017 (1.8 percent).

In sum, neither financial markets nor investors are likely to be overly impressed by today's package, which, it transpires was not even unanimously accepted by the Council. The initial reaction by the euro has been positive simply because neither the cut in the deposit rate nor the boost to QE was as sizeable as it might have been. However, inadequate QE will do little to lift the Eurozone economy off its longstanding sluggish growth path which, in turn, will leave serious doubts about the likelihood of inflation returning to target.

Any bounce in the single currency should be short-lived, especially should the Fed raise rates later this month.

The European Central Bank meets every six weeks to determine the appropriate stance of monetary policy.

The European Central Bank determines interest rate policy at their Governing Council meetings. The Council is composed of the six members of the Executive Council and 17 presidents of member central banks (Bank of France, Bundesbank, etc). The Governing Council meets now meets every six weeks. The European Central Bank has an established inflation ceiling of just less than 2 percent. The ECB's measure of inflation is the harmonized index of consumer prices (HICP). Each member of the Governing Council has one vote and decisions are reached by simple majority. In the event of a tie, the President has the casting vote. No minutes are released so how individual members voted is not known.

As in the United States, European market participants speculate about the possibility of an interest rate change at these meetings. If the outcome is different from expectations, the impact on European markets can be dramatic and far-reaching. The rate set by the ECB serves as a benchmark for all other interest rates in the Eurozone.

The level of interest rates affects the economy. Higher interest rates tend to slow economic activity; lower interest rates stimulate economic activity. Either way, interest rates influence the sales environment. In the consumer sector, few homes or cars will be purchased when interest rates rise. Furthermore, interest rate costs are a significant factor for many businesses, particularly for companies with high debt loads or who have to finance high inventory levels. This interest cost has a direct impact on corporate profits. The bottom line is that higher interest rates are bearish for the stock market, while lower interest rates are bullish.