EMU: ECB Announcement

Thu Oct 26 06:45:00 CDT 2017

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As expected, there were no changes to key interest rates at the ECB's October policy meeting. The benchmark refi rate stays at 0.00 percent and the rates on the deposit and marginal lending facilities at minus 0.40 percent and 0.25 percent respectively. Future repo auctions will continue to be fixed rate and full allotment.

However, the focus was always going to be on what the central bank would say about its QE programme and here the announcement was a little more accommodative than generally expected. Hence, after seeing out this year at E60 billion/month, there will be a reduction in average net monthly asset purchases of E30 billion to E30 billion/month beginning in January. This follows the E20 billion reduction to E60 billion/month made back in April and implies extra QE of E270 billion next year. In addition, and in contrast to most expectations, the revised programme has not introduced a definitive termination date as purchases will continue to run at least through September and beyond if the central bank thinks necessary. The same also applies to the reinvestment of principal payments from maturing securities purchased under the asset purchase programme (APP).

This is all the more significant as forward guidance is unchanged, so the ECB still sees key interest rates remaining at their present levels for an extended period of time, and well past the horizon of the net asset purchases. In other words, a hike in interest rates should be off the table at least until the fourth quarter of 2018. Moreover, the ECB has retained its commitment to increase the APP in terms of size and/or duration should the economic outlook become less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation.

All in all, today's moves underscore the central bank's belief that the economic recovery, while now much more convincing, still needs the help of a very accommodative monetary policy in order to meet its price stability goals. By tapering E30 billion/month rather than the E20 billion/month some had anticipated, it has reduced some of the potential future supply-side pressure from what is already a rapidly dwindling pool of assets eligible for purchase under the APP (notably bunds). Crucially too, unchanged forward guidance and no clear cut-off point for QE should reduce the risk of financial markets tightening monetary conditions prematurely while at the same time reducing some of the investor appeal of the euro.

Accordingly, the euro should see the announcement at least slightly negatively while fixed income and equity markets take solace in what promises to be a somewhat looser overall policy stance than previously expected.

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.