FYI | Oct 07 2011
The ECB takes the pragmatic route as the BOE goes for shock-and-awe
Kathleen Brooks, Research Director UK EMEA, FOREX.com
The Bank of England went for the shock-and-awe approach with its surprise announcement of GBP75bn of fresh asset purchases this afternoon. However, those looking for the ECB to loosen monetary policy further were left wanting. The European Central Bank left rates unchanged at 1.5 per cent; however it announced a raft of “unconventional” measures to provide liquidity to the banking sector.
Overall, today’s meetings show two central banks in close proximity, yet with very different plans on how to support their economies. The Bank of England’s statement that accompanied its decision on QE sounded a warning note on the economic outlook especially the funding situation for the banking sector. Even though the Bank believes that inflation may top a whopping 5% in the next month or so – the highest level since mid-2008 – it thinks there are serious risks that inflation falls below the 2% target in the medium-term.
This suggests that it believes the worst-case scenario could become a reality, so rather than wait to see how the Eurozone crisis pans out and whether or not economic data starts to recover after better than expected PMI data for September, the Bank decided to act now.
The ECB sounded much more cautious. Outgoing ECB President Trichet said that the ECB expects inflation to decline in the medium-term. However, in contrast to the BOE it believes that the risks to price stability are broadly balanced. The risks to the upside include higher taxes as a result of fiscal consolidation measures across the currency bloc, while lower than expected growth is the main downside risk.
So when inflation is already at 3% in the currency bloc, rather than cut interest rates and threaten price stability the ECB decided to target the Eurozone’s most pressing problem – bank liquidity. At least if you help the banks then it may help stave off a credit crunch caused by a Greek default, which could protect growth via the back-door.
The ECB pulled out all of the stops when it came to bank liquidity. The measures it announced include longer-term re-financing operations with maturities of 12 months and 13 months, which will make it easier for Europe’s troubled lenders to access funding. Shorter term financing will also be available for as long as necessary. Three-month financing is on offer and the Bank also announced a further EUR40 billion of covered bond purchases.
The ECB has put itself out there and said it will be the liquidity back-stop for Europe’s financial sector and regardless of the health of the bank it can come to mama ECB for all the financing it needs. But while the markets may have priced in a slight chance of a rate cut, the ECB has taken the pragmatic route.
Although Trichet said the decision to keep rates on hold was not unanimous, it was probably the right decision. Firstly, a rate cut would only have questionable economic benefits since real rates are negative anyway and secondly, it would have evoked the ire of the powerful hawkish faction at the ECB. So Trichet was pragmatic to the end.
Indeed, the Eurozone seems to be stepping back from the brink and fears in the markets about a disorderly Greek default seem to be receding. Hence stocks are higher and after digesting the news from the ECB the euro is also clawing back some gains after coming under pressure in the hours prior to Trichet’s press conference.
What now for the euro and the pound?
In the absence of another flare-up of the Greek crisis and a continuation in the progress by the European authorities and the IMF to 1, re-capitalise the banking system and 2, allow the IMF to purchase sovereign government bonds from the currency bloc then the liquidity measures announced by the ECB are euro positive in our view.
However, we prefer to go long EURGBP than EURUSD. This is because there is still event risk in Europe, which could lead to bouts of dollar strength going forward. In contrast, QE is traditionally very negative for a currency and we may see the pound start to wither going forward. Not only was the amount and timing of QE more than expected, the BOE also left the door open to further QE depending on the economic conditions saying it would keep the scale of the programme on review. EURGBP had a large move to the upside today and is testing its 50-day moving average at 0.8730. Above here we may see back towards the 0.8900 highs of the year.
Overall, we believe the BOE may have jumped the gun with QE this month. The Bank is risking its credibility as defenders of stable prices and even if funding conditions for the UK’s banking sector pick up this will have more to do with developments in Europe than it will from the BOE’s latest move on QE. In contrast, the ECB has taken a pragmatic approach. Now that it has promised to keep liquidity flowing to the banking sector we need to watch to see if this stops speculative attacks on the region’s lenders, which could boost confidence and ultimately growth.
The EU still needs to resolve the Greek solvency issue, but the ECB has done its job and Trichet can leave the ECB with the markets on his side.
The views expressed are the author's, not FNArena's (see our disclaimer).
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