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ECB Less Pessimistic, Rate Cut Less Likely

ECB Less Pessimistic, Rate Cut Less Likely

11.1.2013 8:43

It seems that Mr Draghi and his colleagues on the ECB Governing Council had a very good Christmas. The euro area economic ‘glass’ which they viewed as half empty in early December is now regarded as half full. So, the possibility of a further ECB rate cut that Mr Draghi raised at his press conference a month ago has now faded. The ECB still sees economic risks to the downside and the fragility of economic conditions in the single currency area means a final ECB rate cut shouldn’t be ruled out completely. However, Mr Draghi and his colleagues now appear to take a very different view of prospects than they did a month ago—a change in perspective that seems quite dramatic relative to changes in the economic and financial news-flow in the interim.

The ECB Changes Its Mind A sense that it is the ECB’s perspective rather than the economic and financial situation that has changed is suggested by the very limited changes in the ECB’s opening press statement from a month ago. The press statement tends to give a relatively’ straight’ assessment of circumstances whereas Mr Draghi’s comments tend to provide a more nuanced view of thinking around the Governing Council table. According to the press statement, economic weakness is expected to persist in early 2013 but as was said in December, activity should gradually recover later this year’. As in December, there were tentative signs that a number of indicators began to stabilize, albeit ‘at low levels’. This month’s press statement also repeats the observation that ‘financial market confidence has improved’ but follows this with the word ‘significantly’ rather than ‘further’.

A month ago not markedly different circumstances prompted a split on the ECB Governing Council with some market sources suggesting a majority favoured a rate cut at that meeting. Today, Mr Draghi said the decision not to cut interest rates was ‘unanimous’, a remarkable change in thinking. He went on to cite list of financial market indicators, none of which appears to have changed notably in terms of trend since the December policy meeting. For example, Mr Draghi referred several times at today’s press conference to the drop in Government bond spreads in euro area periphery economies. As diagram 1 below indicates, there has been some easing in spreads in the first week of 2013 but there is nothing exceptional about this in the context of the scale and direction of movements seen in the second half of last year. Indeed, there is quite a similarity between the trend in spreads in late December/early January with that seen in late November/early December.

With markets clearly of the view that global ‘tail risks’ have been removed both by the ECB’s announcement of OMTs last Autumn and the more recent Budget compromise in the US, it would have been very surprising and disappointing if the start of a new year and quarter did not see money going to work in this fashion. For these reasons, Mr Draghi’s notably more positive assessment today can’t be regarded as the inevitable and completely obvious response to a marked change in financial conditions in the past month.

Significantly, the ECB continues to acknowledge that any improvement in financial conditions has yet to feed through to the ‘real’ economy. The January press statement notes ‘there has been little change in credit growth, which remained weak in November’. However, the ECB now suggests some element of this weakness is to be expected by stating that ‘subdued loan dynamics reflect the current stage of the business cycle’ (because credit growth usually lags rather than leads the economic cycle) as well as continuing to recognize more problematic issues such as ‘heightened credit risk and the ongoing adjustment in the balance sheets of households and enterprises’. However, this month’s press statement does not repeat last month’s reference to ‘capital constraints, risk perception and the segmentation of financial markets’ that were judged to be restricting credit supply in a number of countries. So, concerns about constraints on access to credit appear to have eased.

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