Friday, March 27, 2009

ECB explores expansion of economic armoury

From The Financial Times This Morning:

ECB explores expansion of economic armoury

By Ralph Atkins in Frankfurt

Published: March 26 2009 18:56 | Last updated: March 26 2009 18:56

The European Central Bank is actively exploring expanding its armoury to tackle the worst recession seen in continental Europe since the second world war. But it still seems some way from deploying the weapons being used in the US and UK.

ECB policymakers began their pre-meeting purdah on Thursday, a week ahead of their next policy meeting, having made clear there is “room for manoeuvre” to cut interest rates further. That makes possible, but not certain, a 25 or 50 basis point reduction in the main policy interest rate, currently at a record low of 1.5 per cent.

However, the days when central banks used only one instrument to steer an economy are over.

Lucas Papademos, ECB vice-president, heightened expectations that the central bank could soon start buying assets outright after noting in Brussels on Thursday that purchases of private debt securities could “reduce the cost of funding of the real economy, thus helping its recovery”.

Whether and when such a move is taken will depend on the outcome of soul-searching and debate within the ECB’s governing council. Comprising national central bank governors from the 16 eurozone countries and the six ECB executive board members, the council includes nine economic professors, some of whom – such as Athansasios Orphanides of Cyprus – have worked as academics in the US.

One lobby is hesitant to change substantially the way the ECB has operated since the collapse of Lehman Brothers last September paralysed financial markets.

The ECB’s assessment of eurozone prospects has remained broadly unchanged from last month, when it forecast gross domestic product could fall by up to 3.2 per cent this year. Deflation – persistent and general falls in prices – is still seen as unlikely, thanks to the eurozone’s economic rigidities.

Mr Papademos stressed the ECB’s current focus on what it calls “enhanced credit support” – its answer to “quantitative easing” – by which it provides banks with unlimited amounts of liquidity at fixed interest rates.

Banks play a much larger role in supplying finance to the economy than in the US, the argument goes, and the ECB’s assessment is that the “transmission channel” continues to function reasonably well.

A distinct possibility is that the ECB will next week extend the maximum maturity of the funds it lends from the current six months – perhaps to nine or 12 months.

More indicative of the way the debate is going will be what happens to its “deposit facility” interest rate, paid on sums deposited at the ECB overnight, and set at 100 basis points below the main policy rate.

Under “enhanced credit support”, the deposit facility rate has surreptitiously become an important benchmark for market interest rates.

But within the ECB there is resistance to a reduction from the current 0.5 per cent, on the grounds that it would mean, in effect, the ECB was operating a “zero interest rate” policy – a serious taboo for some council members.

Outright asset purchases, as at the US Federal Reserve or Bank of England, would take the ECB still further into new territory.

Conservatives on the council would worry about the political implications. Buying corporate debt could mean it having to favour particular countries or industries – for instance, car manufacturers.

Even worse for some, would be buying government bonds – which would blur the boundaries between central banks and governments and thus threaten the ECB’s cherished independence.

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