ECB Policy Easing Coming to an End

We  are absolutely certain that the ECB will leave rates unchanged this month. The economy appears to have stabilised, financial markets are doing better and, most importantly, the ECB has just launched 3Y LTROs totalling more than one trillion euro, so in Frankfurt they hardly see the need for further easing just now.

The focus will be on whether Mario Draghi keeps the door open for more 3Y LTROs. With so much liquidity in the system, we do not see much prospect  of a  new 3Y LTRO any time soon and, although the ECB never pre-commits, we think Draghi may signal that the February 3Y LTRO was probably the last one.

Markets may also focus on the quarterly staff forecasts. We might see small upward revisions to both the growth and inflation outlook, which further reduces the ECB’s easing bias. Nevertheless, we expect  Draghi  to choose his words carefully as uncertainty remains elevated (the outcome of the Greek PSI is just one uncertainty).

Surging energy prices are beginning to push inflation upward. On previous occasions this has caused the ECB to hike rates. We believe that Draghi will abstain from this kneejerk reaction as he appears to put more emphasis on the view that price pressure should remain limited in an environment of subdued growth.

Market reaction is set to be moderate if the ECB keep rates unchanged and does not change its easing bias too much. If Draghi signals that the easing bias is gone due to improving growth prospects and increasing energy prices, we could see markets react with higher long rates and a EUR/USD strengthening.

ECBs big experiment
The ECB has just undertaken the biggest experiment in its history. The two 3Y LTROs have pumped more than EUR1,000bn in three-year money into the financial system. The impact on short government bond spreads has already been impressive and it is now feeding through the system to longer maturities and other asset classes.

The ECB will now wait and see whether lending will be passed on to the real economy (the monthly loan flows give a first indication that it may have stopped  the credit contraction) and will watch out for any unwanted side effects before considering whether to add more wood to the fire. The ECB hawks, not least Bundesbank Governor Jens Wiedman, are concerned that the LTROs and the easing of collateral rules could have unfortunate implications, including a build-up of central bank imbalances in the TARGET2 cross-border payment system. Draghi may signal that the ECB will stand ready to absorb liquidity at a later stage if needed to avoid rising inflation expectations but we do not expect him to elaborate on what to do about the rising imbalances in the payment system at this stage.

We believe further easing will not be needed and that rates will be kept unchanged for a prolonged period (until 2014). In addition to the abovementioned LTROs, the reasons for the ECB not to cut rates further are as follows. (1) Market sentiment has improved a lot since December (not least due to the above-mentioned LTROs). (2) Economic data are improving and US data in particular shows signs of a recovery. Our soft-data model indicates zero growth in Q1, i.e. the euro area is on the borderline of avoiding a technical recession. (3) Higher oil prices, in combination with a weakening of the euro, have put some upward pressure on inflation, which is now set to remain above 2% throughout 2012. In euro terms, the Brent oil price is now at the highest level ever.

Mario Draghi might go as far as signalling that more 3Y LTROs are unlikely but he would never rule it out. We think that LTRO II was the end of the easing cycle.Risks to our forecast are broadly balanced. Our speed limit approach signals that the ECB should probably cut rates, while a Taylor rule based on core inflation signals that the ECB should be on hold.  However, these models are not able to take the LTRO easing into account.

Staff forecasts
The ECB staff forecasts  will be watched closely. In December the ECB expected the economy to grow 0.3% in 2012 (mid-point estimate) and 1.3% in 2012. Since then the economic outlook has improved but it might be too early for the ECB to lift  its expectations. In any case, the December staff forecast is broadly in line with our current assessment. That said, a small upward revision for 2013 would make sense and would signal another small step away from the easing bias.

Upward revisions to the inflation outlook seem likely.  In December the staff forecast inflation at 2.0% in 2012 and 1.5% in 2013. We think that given the latest surge in energy prices this is on the low side. We  now forecast inflation at 2.2% in 2012 and 1.8% in 2013.

Market reaction
The market is not pricing any rate changes and if the press conference offers little beyond Draghi saying that the LTRO II appears successful, we expect a rather muted reaction.

If Draghi signals an end to 3Y LTRO, we could see long rates moving higher and the curve steepening. A similar market reaction could be seen if he sounds more concerned about increasing oil prices, possibly in combination with modest upward revisions in the staff forecasts for inflation and growth.

On the FX market we could see EUR/USD rise if Draghi signals an increased focus on inflation and thus a risk of rate hikes earlier than previously expected.