EMU: ECB Announcement

Thu Dec 08 06:45:00 CST 2016

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As widely expected, the ECB's last policy setting meeting of the year ended without any changes to key interest rates. The benchmark refi rate stays at 0.00 percent, the deposit rate (crucially) at minus 0.40 percent and the rate on the marginal lending facility at 0.25 percent. However, the central bank did announce both an extension to the current QE programme as well as a future reduction in its scale that may well be viewed as the first step on the path to tapering.

Monthly asset purchases, previously tentatively scheduled to end in March 2017, remain pegged around E80 billion a month until this date. However, thereafter the purchases will be shaved to a monthly E60 billion through the end of the year (or beyond if necessary). This will add an additional E540 billion of liquidity versus the March cut-off date. Financial markets had been looking for a 6-month extension at the previous rate (worth E480 billion) so, if anything, the ECB has been more generous than anticipated.

This should offer some reassurance that the monetary authorities' stance will remain very accommodative throughout 2017, despite the apparent tapering. Indeed, the ECB's statement indicated that the new asset purchase schedule is flexible in terms of both duration and size according to how the economic picture evolves. The increase in planned purchases also saw some technical adjustments to the eligibility criteria for the ECB's Asset Purchase Programme (APP) to ensure that supply remains adequate. These include reducing the lower maturity bound on selected assets from 2-years to 1-year and allowing some purchases of assets that yield less than the minus 0.40 deposit rate, if needed. The changes will be introduced from January next year

For once the ECB was able to meet against a rather more upbeat economic backdrop with signs that real GDP growth this quarter could accelerate for the first time since the end of last year. That said, the upswing is still quite sluggish and lacks regional balance - too much of the work will be done by Germany and, of course, underlying inflation trends remain both flat and far too low (around 0.8 percent).

To this end, the central bank's new economic forecasts are hardly any different from their September counterparts and so, from a policy angle, justify more of the same. Thus, real GDP growth is still estimated at 1.7 percent in 2016 and also at 1.7 percent in 2017 (versus 1.6 percent in September). Both 2018 and 2019 are put at 1.6 percent. There are similarly only minor changes to the inflation projections which have 2016 at 0.2 percent, 2017 at 1.3 percent and 2018 at 1.5 percent. Inflation in 2019 is expected to edge up to 1.7 percent.

In sum, today's announcement probably constitutes a compromise between those Council members unconvinced that the Eurozone economy is out of the woods and those increasingly worried about what damage such a high degree of monetary accommodation might be doing to the longer-term outlook. For bond markets, any hint of tapering was never going to sit well so the prospective cut in the rate of monthly purchases was not good news. However, at the end of the day, the central bank is still pumping in a considerable amount of liquidity so any losses should be mild. Much the same applies to equities.

For the euro, the prospect of a sustained loose ECB policy combined with a probable Fed tightening next week was probably already priced in. Even so, today's action hardly improves the European unit's short-term investor appeal.

Market Consensus Before Announcement
Although there is little speculation about an outright ease, the market consensus is for an extension of the current QE programme by six months to at least the end of September 2017.

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.