Tuesday, September 4, 2012

ECB preview - Waiting for ground-breaking action

This week could be the most groundbreaking one in the ECB’s history. When the ECB meets on Thursday, it will discuss the details of its new bond-purchasing programme. For some, the new plan marks the final end of the Bundesbank doctrine; for others, it is a necessary evil to calm the crisis. It is obvious to us that Mario Draghi’s congeniality and some vague words alone will not have the same calming effect as in August. In our view, the ECB might eventually present targets for short-term bond yields linked to the refi rate. However, not all the detail might be revealed this week, perhaps because there is not yet full agreement within the Governing Council, but maybe also to keep pressure on peripheral governments.

Recession feeling increases. Anything else than a downward revision of the ECB staff projections would come as a surprise. Although second-quarter growth was slightly less dramatic than expected, thanks to strong German growth, all confidence indicators point to a further worsening of the economic situation. The best expectation for an end to the recessionary feeling is currently for the end of the year. A downward revision of the ECB staff’s growth projections could be a good justification for a rate cut at this week’s meeting. However, in our view, a rate cut would only become a policy option if the Governing Council cannot find an agreement on the new bond purchasing – a kind of sweetener.

All eyes on bond-buying plan. A further deterioration of the economic outlook should not be the main topic of this week’s meeting. All eyes are on the much-awaited plan for ECB bond purchases, an SMP 2.0. Two things seem certain: first, any ECB bond purchasing will be conditional on a country applying for an EFSF/ESM programme. Preferably, the ECB would even like to see the EFSF/ESM purchase bonds in the primary markets before it gets active in the secondary market itself. Second, the ECB will purchase only short-term bonds. For the rest, however, it remains almost anybody’s best guess what Draghi will present on Thursday.

How could it look like? In our view, the ECB will eventually present explicit targets for short-term bond yields (probably up to three years) under an SMP 2.0. Of course, explicit targets contain the risk of inviting speculative attacks. However, implicit or secret targets are harder to defend in a credible fashion. To avoid the issue of setting “neutral” levels for bond spreads and to stress the fact that SMP 2.0 is mainly targeted at the transmission of monetary policy, the ECB could actually link targets for short-term bond yields to the refi rate and not another benchmark bond.

High risks, and devil remains in the detail. Obviously, there are still many potential risks and unsolved issues in any new ECB bond purchases. In particular, the issue of conditionality should be more of a concern to the ECB than future inflation risks. Will the ECB implicitly put its destiny in the hands of the Troika, making bond purchases exclusively dependent on an EFSF/ESM programme? Moreover, issues of whether or not to sterilise also seem tricky, given the potential size of the new plan. Obviously, the new bond purchasing plan will bring the ECB into uncharted and dangerous territory. However, we believe that with the August announcements the ECB has already passed the point of no return.

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