EMU: ECB Announcement

Thu Oct 20 06:45:00 CDT 2016

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The ECB's October policy announcement contained no surprises for financial markets. Key interest rates were kept unchanged at their September levels leaving the benchmark refi rate at 0.00 percent and the rates on the deposit and lending facilities at minus 0.40 percent and 0.25 percent respectively. The asset purchase programme (AAP) was similarly maintained at an average of E80 billion/month through at least the end of March 2017 and in any case until there is a sustained adjustment in the path of inflation consistent with its near-2 percent medium-term target.

ECB Chief Draghi's press conference was largely a non-event. There was never any expectation of a move on rates today - and getting a consensus would have been nigh on impossible anyway - but there were limited hopes that the President might drop some hints about an extension to the QE schedule. However, if, as seems very probable, the programme will indeed run beyond next March, market notification will have to wait until at least the next and last meeting of the year (8th December). Apparently the Council did not consider the issue today, neither did it discuss possible future tapering.

Similarly, there was no fresh news on how the central bank will tackle the issue of potential supply shortages of eligible assets that the ECB can buy under the APP. The increase in bond yields this month (10-year bunds are up from minus 0.119 percent at the end of September at 0.042 percent) has reduced pressure for immediate action but some change to existing rules will be hard to avoid later on.

The central bank's view of recent economic developments would seem little changed from the last meeting. Third quarter real GDP growth is expected to have been much the same as the second quarter's modest 0.3 percent while an anticipated near-term acceleration in inflation is seen mainly reflecting positive base effects. As stated previously, the base line scenario remains subject to downside risk.

So, for now the ECB remains in wait-and-see mode, and not without some justification given recent economic data and the seemingly diminishing returns generated by policy changes. Looking ahead, the December discussions will incorporate updated economic forecasts for the first time stretching out three years. These could provide the trigger for a fresh monetary ease and certainly without some firming in the data, financial markets will be disappointed if the policy stance then remains the same as it is today.

The European Central Bank (ECB) sets monetary policy for all members of the Eurozone. The highest decision-making body is the Governing Council which comprises the six members of the Executive Board and the nineteen presidents of member central banks. Policy meetings take place roughly every six weeks but, due to the sheer number of participants, a rotation system has been introduced so that the total number of votes is capped at twenty-one. The benchmark interest rate is the rate on the main refinancing operations (refi rate) which sits between the marginal lending facility rate and deposit rate. The ECB's primary objective is price stability, which is based upon a near-2 percent target for the annual inflation rate.

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.