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Weekly Economic Commentary

 
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The European Central Bank Holds Court Tomorrow

December 7, 2011

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All eyes are on the European Central Bank’s (ECB) announcement tomorrow morning. The Bank of England (BoE) also meets tomorrow; the Fed’s FOMC meeting is scheduled for December 13. Markets are looking for the ECB to lower the policy rate from the current level of 1.25%. The ECB unlike the Fed and the Bank of England held the policy rate at 1.00% as the global financial crisis unfolded in late-2008. It is strongly likely that Mario Draghi will announce a rate cut. But, markets are looking for more than a reduction in the policy rate.

DEC 12/7/2011 chart 1

The main concern is about measures the ECB will offer support to the banking system. The coordinated central bank of November 30 to ease pressures on dollar funding has led to the ECB lending $51 billion to 34 banks. These data denote the extent of strains in the European banking system. The recent accommodation through reduced rate on dollar loans is still far lower than the $171 billion dollar funding the ECB provided at the peak of the crisis after the collapse of Lehman Brothers. The longer term problem of bank recapitalization is yet to be addressed. The ECB has purchased debt of the peripheral nations under the Securities Market Program. Last week President Draghi hinted that more aggressive ECB support is possible if there is a “fiscal compact” put in place. The fiscal prudence rules are expected to be part of the announcement on December 9. Therefore, President Draghi will probably save the measures of support that will lead an increase in the ECB’s balance sheet to a later date, awaiting the details of the EU Summit communiqué on December 9.

In the meanwhile, there are other options the ECB could include in tomorrow’s announcement. First, the term of ECB loans to banks could be extended to more than year, which is the current structure. Second, the ECB could create more breathing room for bank by widening the range of assets considered as suitable collateral. Critics will continue to point out that such actions will changes the risk profile of the ECB’s balance sheet. Nevertheless, these are extraordinary times calling for extraordinary actions. These measures would bolster confidence in the banking system and reduce counterparty risk. Overnight bank deposits at the ECB, despite a penalty attached to them, have risen to €333 billion, reflecting the reluctance to lend in the interbank market.

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The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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