Will the ECB Wave its Magic Wand?

Another interest rate decision tomorrow – what will Jean-Claude Trichet and the ECB pull out from the monetary policy hat this time?

The European Central Bank (ECB) is accountable for the monetary policy of the 16 member countries of the Euro zone. The bank has control of the region’s money supply and its cost (a.k.a the interest rate) to achieve their objectives concerning economic growth and stability.

With the complexities of having to consider the economies of 16 different nations, the ECB has stated that its chief purpose is that of price stability. In other words, the primary driving force behind the bank’s interest rates decision is inflation, with the goal being to keep it at just below 2%. The Harmonized Index of Consumer Prices (HICP), which is a weighted average of the price indices of the countries which use the euro as local currency, is used to measure inflation in the Euro zone.

Year-on-year inflation in May registered a flat reading (0.0%). At that time, the ECB slashed its target interest rate to 1.0% in an effort to spur economic activity and attain its inflation target. With a global recession at hand, simply using inflation as a guideline for the bank’s monetary policy just doesn’t cut it anymore. The benchmark interest rate is already at an all time low at 1% yet credit is as tight as ever, with loan growth at just 1.8% year on year this past May. According to Axel Weber, an ECB member known for his hawkish comments, the central bank has maxed out the interest rate reductions and that additional steps are not necessary.

During the bank’s last monetary policy meeting, it decided to keep its target interest rate unchanged and shifted its focus to unconventional quantitative easing actions in an attempt to create liquidity in the market… Well, not really… The ECB did it only to the tune of €60 billion – chump change compared to what the US and UK has done. They also plan to spread out the purchases over the next year. So not only is the amount minimal, actual money entering credit markets will be in small increments.

What is important to know is that quantitative easing, on its own, doesn’t really devalue a currency. The thing with QE is that it alters currency speculators outlook on inflation. Simple supply and demand – more money (supply) means lower value. This doesn’t mean that it will actually happen though. Notice what happened when the ECB announced their bond purchase program – traders took this as a sign to buy the euro because the ECB’s plan was small in comparison to the US and UK plans. See, it’s all relative!

Given latest data showing that inflation is near zero, could this spark more motivation to expand this program? With a puny program and low inflation, this could provide the right formula for them to expand quantitative easing measures…

Recent comments from ECB members suggest that further easing seems to be scrapped out of the picture. Last week, ECB President Jean Claude Trichet said that there is no more room for the government to accumulate more debt in order to fight the economic crisis. Nout Wellink, an ECB member from Netherlands, echoed Trichet’s comments in saying that an expansion of the covered bond purchases is currently not foreseen.

The sit-and-wait strategy seems to be the consensus for ECB members who believe that it’s too early to start planning an exit from the stimulus measures. “Exit strategies can only be planned when you have clear signs to exit, and it’s very early for this. But it’s never too early, on the other hand, to think about exit strategies. It’s too early to start to plan,” says Jose Manuel Gonzalez-Paramo, a member of the Executive Board.

Knowing that the ECB has been traditionally “slow” to act, many do not expect there to be a rate cut or any expansion of its quantitative easing policies. The base rate currently stands at 1.00%, an all-time low for the euro-zone, but still higher than the US and UK’s rates. Economists do not expect the rate cut given the ECB’s past and its stance towards inflation. The rates cuts have been smaller and smaller recently, probably on the notion that “they are as low as they can get”. Given this, and the ECB’s fear of spiking inflation, we probably shouldn’t expect a rate cut, much like what happened last June 4.

Sigh. If only saying a simple spell and the wave of a wand could make this recession disappear. But no, managing the goals and interests of 16 different nations is much more difficult. Most likely, Thursday could just be another day in the forex world as the wizards at the ECB remain bewitched under its current spell… err, policies.