27 August 2007

EZA 807 Briefing Note: ECB Observer

ECB liquidity moves and policy stance
DESPITE RECENT TURMOIL AND LIQUIDITY INJECTIONS, EZA SEES ECB STILL IN TIGHTENING MODE, WITH 4 1/4% 'REFI' RATE LIKELY ON 6 SEPTEMBER AND 4 1/2 % STILL POSSIBLE BY END-YEAR 1. At the same time as injecting liquidity over the past fortnight to ease shortages in the money market, the ECB has been at pains to emphasise that these moves in no way denote a change in its monetary policy stance. ECB press releases have stressed that its operations to provide additional liquidity were technical measures aimed at supporting the normalisation of the functioning of the euro money market and that the position of the Governing Council on its monetary policy stance remained as President Trichet had stated at his press briefing on 2 August. The key phrases in that short statement were that strong vigilance was of the essence - the usual coded signal for a strong likelihood that the Governing Council would decide the following month to raise the ECB's key rates - and that the Governing Council never pre-commits - in other words, the final decision is always contingent upon economic and monetary developments in the intervening period. 2. In the view of EuroZone Advisors, speculation that the recent turbulence in financial markets would cause the Governing Council to stay its hand or even to cut rates when it meets on 6 September is ill-founded. The ECB will wish to maintain a clear distinction between its function as lender of last resort, meeting temporary liquidity shortages in the interests of orderly markets, and its monetary policy obligations in the pursuit of price stability. It is possible that some members of the Governing Council might argue in favour of waiting a little longer, until October, to ensure that the dust has really settled, before tightening policy further, but most members are likely to see this as putting at risk the ECB's credibility, given that at the beginning of August it had gone out of its way to prepare the markets for a September move. Despite the increased volatility in the markets, there has so far been little change in the economic and monetary fundamentals on which the ECB bases its policy actions. A 25 basis point rise, therefore, in the ECB's main refinancing rate on 6 September, taking it to 4 1/4%, remains highly likely. Looking further ahead, if confidence among economic agents proves to have been lastingly dented, prospects for economic growth in the eurozone might need to be revised downwards, with a consequent diminution of the perceived risks to price stability. The ECB might then see less need to push its 'refi' rate beyond the 4 1/2% level that we still consider likely by the end of this year.

© Graham Bishop