ECB: Rates On Hold

At Friday’s meeting, the ECB Governing Council decided to leave key policy rates unchanged. President Draghi did not completely close the door to further rate cuts. Nevertheless, we think that the Bank will embark in further refi rate cuts only if the economic conditions drastically deteriorate

At today’s meeting, the ECB Governing Council decided to leave key policy rates unchanged. Today’s decision was unanimous, while in December there were some members favouring an interest rate cut.

President Draghi highlighted the significant improvement of financial conditions over recent months. CDS, yields and spreads on sovereign and banking securities have been decreasing while volatility in financial markets eased. In addition, current account deficits and Target2 imbalances have been narrowing, while there are signs of inflows of capitals in peripheral countries.

Yet, Mr. Draghi acknowledged that the activity is still weak; the ECB expects it to recover only gradually throughout 2013. Indeed, all the positive effects observed in financial markets are not filtering through the real economy. Hopefully, they will progressively pass on to the real economy during the year, stimulating confidence, credit growth, employment and eventually activity.

Will the ECB cut key policy rates in the future? President Draghi did not completely close the door to an interest rate cut going forwards. Nevertheless, the Bank will probably embark on further refi rate cuts only if the economic conditions drastically deteriorate. While a refi cut is possible, although not likely, a decrease in the deposit facility rate (DFR) is highly unlikely. Since the ECB is conducting all its refinancing operations at fixed rate and full allotment, the DFR became the key policy rate reflecting the ECB’s monetary policy stance. Since then, the O/N Eonia has been trading near the DFR.

Cutting below 0% the DFR would inflict a penalty rates to those banks which have excesses of liquidity and made a large use of the deposit facility. Note that starting at the end of January and with weekly frequency, banks will have the opportunity to make early repayments of the sums borrowed as part of the first special 3-year LTROs. The early repayment for the second special 3y LTRO will begin at the end of February.

By Clemente DE LUCIA

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