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ECB in wait and see mode

ECB in wait and see mode

5.12.2012 10:52

At their November meeting, the ECB didn’t change its policies and neither there were signs new major policy initiatives were close at hand. There were some subtle shifts in ECB thinking that kept the door open to a further monetary easing, but this was “offset” by Mr. Draghi’s comments that suggested the ECB had become more comfortable that the risk of “tail” events had diminished considerably.

Nevertheless, away from tail risks, the weakening of the economic outlook means the question of further ECB policy action could be again under consideration. We consider below the changes that occurred in the past month regarding the tail risks and the economic developments before drawing our conclusion that while the door for a further easing of policy remains open, the ECB will keep its policy stance unchanged at the December meeting.

Tail risk receding further
A risk-on-rally started in earnest when ECB president Draghi made clear at a London conference at the end of July that the ECB would do whatever is needed to defend the integrity of the euro area. In a follow-up action the ECB unveiled the details of its new bond buying programme (OMTs) at the September meeting. ECB bond buying is conditional on the country request for an ESM bail-out and the acceptance of conditionality by the requesting country.

This prospect improved conditions throughout all markets. This is illustrated here by the graph of the Italian 10-year BTP yield. Since the Draghi comments it dropped more than 200 basis points to about 4.40%, below the yield level reigning just before the mid-2011 crisis hit the country. This improvement was visible in all other key markets.

The ECB is of course happy with the successful containment of the tail risks, but is at the same time concerned that governments may become complacent and delay the vital, but often painful, measures to tackle both country specific imbalances and the structural faults in the euro construction. The ECB fears that lower Spanish yields Italian 10-yr yield drops sharply Weak eco outlook and slowing inflation suggest ECB could debate a rate cut…

….but ECB will stand put as it won’t give governments the cover to kick the can
…. further down the road on crisis fighting

Benefits of refi-rate cut modest as eonia is trading at a few basis points ECB in wait and see mode have allowed the Spanish government avoid asking for formal support for the sovereign (although formal banking assistance has been requested). Worryingly, a renewed crisis may be needed to convince the Spanish government to request such support. Similarly, there are signs. Governments are backtracking in relation to the banking union, that was in principle accepted at the June EU Summit. So, the main message of Draghi on Thursday is likely to be that the ECB has done its job by readying its OMT bond buying programme. The ball is now firmly in the court of the policymakers and Mr Draghi may urge early decisive action.

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