Merk Investments: ECB Confident on Course

The European Central Bank (ECB) cut its benchmark interest rate by a quarter percent to 1.25%; the cut was less than the 0.5% expected by many, but in line with our own estimate.

The European Central Bank (ECB) cut its benchmark interest rate by a quarter percent to 1.25%; the cut was less than the 0.5% expected by many, but in line with our own estimate. The cut followed a cut of 0.5% in January and a pause in February of this year. The ECB also lowered the interest paid on deposits at the ECB to 0.25% from 0.5%, not moving to 0% as some anticipated.

We particularly noted in ECB President Trichet’s remarks:

The ECB considers the world economy very weak and expects a “gradual recovery over the course of 2010.” We note that estimates for a recovery are being pushed out further into 2010 by central bankers around the world.

The ECB does not exclude further rate cuts, but states that any further rate cuts be “measured”. While it is fair to assume that the ECB considers all its policy actions measured, we believe the wording was chosen to signal to the market to expect no more than a 0.25% rate cut in May.

Trichet emphasized that six and twelve month money market rates are lower in the eurozone than in the U.S. He attributes this partially to the spread between the interest paid on deposits and the ECB’s benchmark interest rates, as well as the liquidity facilities provided by the ECB. While he does not rule out a lowering of this spread, it re-emphasizes Trichet’s reluctance to move to an interest rate policy near zero.

Trichet announced that further non-standard measures the ECB may take will be discussed in May. He stressed that the ECB was the first central bank to engage in non-standard measures at its August 9, 2007, meeting. The ECB has primarily relied on providing unlimited supply of liquidity to the banking system as well as an enlargement of collateral accepted for its credit facilities.

Trichet says any new policies must preserve the ECB’s reputation as being an anchor of stability. The confidence of the public in the ECB is paramount. It is the loss of confidence and trust that is a root cause of the economic crisis. It is in this “spirit” that the ECB will “meditate” about further policy actions. As a result and because the ECB’s only target is the anchoring of price stability, we have a difficult time imagining that the ECB will engage in large scale government bond purchases, which is one of the open questions market observers have.

Trichet made it very clear that the eurozone is not experiencing deflation, but dis-inflation, primarily caused by a drop in commodity prices. He says inflation rates may turn negative, but this would be a welcome stimulus if caused by lower commodity prices. This is in stark contrast and we read it as a direct criticism of Swiss National Bank (SNB) Vice President Philipp Hildebrand, who said earlier in the day that the SNB will continue to intervene in the currency markets to prevent the Swiss franc to gain as long as needed to fight the risk of deflation; Hildebrand said, “it’s about preventing” such a development “by all means.” We are rather concerned about the developments at the SNB.

The euro reacted positively to the prepared remarks and remained strong during the Q&A discussion that followed. It is our understanding that the ECB does not favor intervening in the currency markets. We will have to wait for May’s discussion on non-standard measures, but taking today’s comments together with previous comments, we believe the ECB would be highly reluctant to engage in non-standard measures that are a direct assault on the currency, such as large scale purchases of government debt as the Fed has started to embark on.

Finally, while it has become standard language in the ECB’s prepared remarks, Trichet mentioned that one of the risks to consider is a disorderly adjustment of global imbalances. Just because this risk has been with us for some time does not make it less of a risk. The disorderly adjustment of global imbalances is a thinly veiled reference to a possible dollar crash. As the Fed is now engaged in activities that may be designed to weaken the dollar, such as the purchases of Treasury Bonds, this risk has only increased.

Axel Merk
Merk Investments
President and Chief Investment Officer