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ECB drops old philosophy but is short of new options

The European Central Bank's vow last week to keep record-low interest rates "at present or lower levels for an extended period" is a big philosophical shift for a bank that used to insist it would not tie its hands.

On the face of it an unprecedented and bold move, such 'forward guidance' is really just formal recognition of what markets expected anyway, and the bank's realistic policy options are narrowly confined.

ECB President Mario Draghi, who vowed a year ago to do "whatever it takes" to save the euro, said the move was driven by market volatility, which set in after the U.S. Federal Reserve last month set out a plan to begin slowing its stimulus.

"Draghi's message was a clear break from the 'we never pre-commit' ECB of the past," said Andrew Bosomworth, a senior portfolio manager at Pimco, the world's largest bond fund.

"The Governing Council wants the world to know they are on a different timetable to the Fed," he added.

But the ECB's steer is more flimsy than the guidance offered by the Federal Reserve or even the Bank of England, which suggested last Thursday it could give more detailed guidance on monetary policy as soon as next month.

The risk is that when the Fed does begin unwinding its stimulus, the ECB's words won't be enough to protect the euro zone from the fallout, and market interest rates will rise - a scenario that would make the bloc's escape from crisis harder.

Then the ECB would have to back up its words with action, and the policy options it has are unpalatable to many at the bank - a conservative institution focused on inflation fighting.

"What they have done is very soft. We don't know what 'extended period' is," said Anders Svendsen, analyst at Nordea.

RBS economist Richard Barwell agreed: "Nobody thought they were going to hike rates ... It was a statement of the obvious."

A Reuters poll of more than 60 analysts conducted before last Thursday's policy meeting showed they already expected the ECB to keep its main refinancing and deposit rates on hold at their record lows until at least the end of next year.

The ECB duly held its main rate at 0.5 percent and left the deposit rate it pays banks for holding their money at zero.

Words in Action

The phrasing of the ECB's guidance is crucial. Draghi said the Governing Council "expects" rates to remain at their existing level or go lower, he did not make a cast-iron promise.

The morning after the policy announcement, Governing Council member Erkki Liikanen qualified the pledge to keep rates low, saying it is good for as long as the economy remains weak.

"When there are changes, they will be taken into account. Everything depends on the development of the economy," he told Finnish broadcaster YLE.

A sudden, if unlikely, pick-up in the euro zone economy or an oil price shock could easily force a change in policy.

The more immediate threat to the euro zone, however, is fresh market turmoil when the Fed begins unwinding its stimulus.

Federal Reserve Chairman Ben Bernanke's announcement on June 19 that the U.S. economy central bank was likely to begin slowing the pace of its bond-buying later this year sent peripheral euro zone sovereign bond yields sharply higher.

A political crisis in Portugal pushed yields on its benchmark bonds above 8 percent last week, near levels that forced it to seek international aid two years ago.

RBS's Barwell said the ECB's guidance should inoculate shorter-dated bond yields from the impact of the Fed 'tapering'.

"What happens if that fails? What happens if the contagion comes nonetheless? Then they are back in the ball game of they might have to do something rather than talking," he said.

Yet the conditions attached to the ECB's sharpest policy tool - its bond-buying program known as Outright Monetary Transactions (OMT) - mean the central bank cannot use it to help Portugal at the moment, or even Spain or Italy for that matter.

OMT requires a country to seek outside help from the euro rescue fund - which neither Rome or Madrid have done - and be issuing debt regularly on the bond market for the central bank to intervene and buy its bonds.

Portugal has been issuing Treasury bills but is not regularly issuing longer-dated bonds across the yield curve. Draghi said last week the ECB rules on the OMT were unchanged, all but directly leaving Portugal alone to resolve its crisis.

That leaves more specific guidance - with a clearer timeframe - or straightforward rate cuts as alternative options. Draghi said the ECB discussed cutting rates last week.

The trouble with rate cuts is that the ECB's low rates are not reaching all euro zone economies evenly, with lenders in crisis-hit states passing on higher funding costs to customers.

A further option is to offer banks another batch of ultra-cheap long-term loans, known as LTROs. The ECB lent banks a total of more than 1 trillion euros in such twin three-year lending operations in December 2011 and February 2012 - a ploy that Draghi said "avoided a major, major credit crunch".

The interest rate on the loans, which banks are now repaying early, is tied to the ECB's refinancing rate. Barwell believed a new LTRO would need to be offered at a fixed rate for banks to take it up, and thereby push down market interest rates.

"I think it can't be the same as what's been done before," he said. "My view is that they've got to make it more attractive, and the key thing to do would be a fixed-rate LTRO."

The International Monetary Fund is already pressing the ECB to take such action. In its annual Clause IV consultations with Italy, the IMF on Thursday called for the ECB to complement Italy's reform efforts with direct assets purchases and more bumper loans to euro zone banks.

"Direct asset purchases by the ECB, such as for SME credits, another LTRO of considerable tenor, and lower haircuts on eligible collateral would help lower bank funding costs and lending rates," the IMF said.

Full-on asset purchases with a U.S.-style quantitative easing program could depress yields further out than the 2-3 year maturities that Pimco's Bosomworth said the ECB's commitment to low rates for an "extended period" would cover.

But the conservative DNA of many ECB policymakers makes them averse to such radical policy steps.

Going further would be much harder for the ECB. Draghi stressed last week that the move to take forward guidance was "unprecedented" and a "very significant step".

"This was as strong a commitment as one can get that the ECB will remain accommodative for as long as needed," said Bosomworth.

[Source: By Paul Carrel, Reuters, Frankfurt, 08Jul13]

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