ECB Fleshes Out Bond-Buying Plan, Keeps Interest Rates at 0.75%

The European Central Bank (ECB) kept its key interest rate unchanged at a record low of 0.75% at its 6 September policy meeting. The ECB had previously cut interest rates by 25 basis points from 1.00% to 0.75% at its June meeting, which marked the first time that they had gone below 1.00%. Of greater interest at the September policy meeting, and undoubtedly more important given the pressing need to bring about a sustained easing of Eurozone sovereign debt tensions, were the bank's statements fleshing out its bond-buying plans that were originally announced at its 2 August policy meeting. These plans followed ECB president Mario Draghi's pronouncement in late July that the ECB would do "whatever it takes to preserve the Euro; and believe me, it will be enough".

In actual fact, it is very clear that key to the Eurozone's survival in its current form will be the success of governments in problem countries in undertaking structural reforms and other measures that lift their competitiveness and improve their underlying fiscal positions. In addition, success will also depend on Eurozone policy-makers ultimately taking major steps towards greater fiscal and banking integration. Having said that, the risk premia in bond markets that have sent the yields of particularly Spanish but also Italian bonds to dangerously high levels constitute a major threat to the stability of the Eurozone, and one that needs to be tackled urgently. As a result, the ECB is treading a fine line by trying to put in place a strong enough bond-buying programme that impresses the markets and potentially leads to a sustained, marked reduction in problem countries' risk premia, while at the same time keeping major pressure on the problem countries to commit to structural reforms and see them through.

In many respects, the Outright Monetary Transactions (OMT) programme seems to satisfy these conditions. The markets should be impressed by the fact that there are no ex ante size limits to the ECB's purchases of a country's bonds and that the ECB will accept the same (pari passu) treatment as private creditors in the case of a default. While there had been some speculation that the ECB could indicate a targeted ceiling for a country's bond yields or a maximum spread differential, the unlimited size of the bond buying should be a powerful measure. The bond buying will be focused on sovereign bonds with a maturity between one and three years. It will be fully sterilised. To keep pressure on countries to commit to, and see through, major structural reforms and corrective measures, the ECB is imposing strict conditionality on its bond-buying programme. The ECB will not buy a country's bonds until its government has requested assistance from the European Financial Stability Facility (EFSF)/European Stability Mechanism (ESM) and then signed up to either a full macroeconomic adjustment programme or a precautionary programme. Critically, the ECB will only consider a bond purchase if a country fully respects its programme. If non-compliance occurs, the ECB may terminate or suspend its bond buying. The ECB will also ask the IMF to help countries monitor compliance with the programmes. Draghi indicated that there was only one dissenting voice within the ECB's Governing Council over the bond-buying plans. Although Draghi did not name the dissenter, specualtion that it was Jens Weidmann, the head of the Bundesbank, was later confirmed by the German central bank.

The ECB has undeniably gone a long way towards providing an effective backstop. Ultimately, however, the success of its actions will depend critically on whether or not problem countries are prepared to approach the EFSF/ESM for assistance, agree to specific corrective actions, and then see them through over a sustained period. Attention will now be focused on the Spanish government in particular, and also on the Italian administration.

Outlook and Implications

The ECB's interest-rate decision very much took a back seat to the fleshing out of the bond-buying programme, and the suspicion is that the discussions within the Governing Council were dominated by the details of the OMT. As a result, little time may have been left for discussing the case for taking Eurozone interest rates down to a record low of 0.50%. Certainly, Draghi paid little attention to the ECB's decision to keep its key interest rate unchanged at 0.75% at his press conference, although this largely reflected the dominant orientation of the questions towards the OMT. He merely commented that the ECB had discussed cutting interest rates at the September meeting but that the decision was that it was not the right time to do so.

This suggests to IHS Global Insight that the ECB is open to taking interest rates down to 0.50% from 0.75%, should the Eurozone fail to show any signs of significant economic improvement over the coming weeks. Moreover, although the ECB now expects Eurozone consumer price inflation (which rose back up to 2.6% in August from 2.4% in July) to be higher than previously anticipated as a result of renewed increases in euro-denominated energy prices, it still sees inflation falling below 2.0% over the coming year. Critically, the ECB sees underlying price pressures remaining moderate over the policy horizon, with inflation expectations anchored. Significantly, the new Eurozone GDP and consumer price inflation forecasts from the ECB's staff suggest that a further interest-rate cut is highly possible. The centre points of the forecasts show GDP contraction of 0.4% in 2012 and growth of just 0.9% in 2013. For inflation, the central forecasts are 2.5% in 2012 and 1.9% in 2013. This suggests that consumer price inflation will be below 2.0% later on in 2013, in line with the ECB's mandate of "close to, but just below 2.0". Furthermore, the ECB regards the risks to the growth outlook to be slanted to the downside, while inflation risks are viewed as balanced over the medium term. With the Eurozone seemingly heading for further GDP contraction in the third quarter and the prospects currently looking far from bright in the fourth quarter, we expect the ECB to trim interest rates from 0.75% to 0.50% before the end of the year, with November now looking a strong possibility