ECB Preview: Keep An Eye On The Excess Liquidity‏

We expect no new measures from the ECB this month though an easing bias remains. Mario Draghi may indicate that the Governing Council is getting slightly more optimistic on the growth outlook.

Soft data has begun to improve, peripheral spreads have tightened further and money growth has picked up speed, which reduces the likelihood of further easing. We expect the ECB to keep rates on hold throughout 2013.

However, there is one caveat. From 30 January 2013, banks can return the liquidity they took on the three-year LTRO in December 2011.

If several hundred billion euro of excess liquidity is promptly returned, this may push up market rates and could potentially trigger an ECB response.

First signs that the economy has bottomed out
Since last month’s meeting, there have been tentative signs that the economy is improving. Soft data has begun to improve, peripheral spreads have tightened further and money growth has picked up a bit more speed. M1 growth now stands at 6.7% and as much as 17.2% in Germany – sending a fairly strong signal of a rebound in growth on a six-month horizon.

Mario Draghi, the ECB president, has partly recognised this. In his speech to the European Parliament a week before Christmas he said:

We expect economic weakness to extend into next year with a very gradual recovery in the second half of the year. The recovery is expected to be supported by strengthening global demand, a highly accommodative monetary policy stance and significantly improved confidence in financial markets, all of which should work their way through to spending and investment decisions.

In such an environment, the ECB governing council will save its ammunition for later. Indeed, several governing council members have been busy dampening expectations of new rate cuts which were fuelled at last month’s governing council meeting. Some doves in the governing council will still argue for further easing but it is hard to see how the hawks can agree with this when there are tentative signs that growth bottomed in Q4.

Recent monetary developments may add to some hawks' concerns about the inflationary risks of the already very loose monetary policy. At the moment an activation of the OMT programme also seems unlikely. The announcement of the programme has been so successful in bringing down sovereign spreads that the activation of the programme may never be needed.

This would be one of the biggest successes in the ECB’s history. We anticipate a gradual economic recovery in 2013 and thus the ECB could be on hold for a long time. We expect policy rates to be unchanged until 2015 when the ECB may begin to hike rates at a measured pace.

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