ECB, BoE Hold Steady Amid Uncertainty

As expected, the European Central Bank and the Bank of England kept their benchmark interest rates unchanged at their respective policy meetings on Apr. 8, and the BoE also left its asset purchase target unchanged. Both central banks are likely to remain on hold in the coming months.

The ECB left the refinancing operations, or refi rate, unchanged at 1.0%. ECB President Jean-Claude Trichet repeated in a statement that "current rates remain appropriate." Taking into account "the information and analysis" that have become available since the last ECB meeting in March, price developments are "expected to remain moderate over the policy-relevant horizon." Data confirmed that the economic recovery remains on track, although it is "likely to be uneven." The ECB continues to expect moderate growth "in an environment of uncertainty."

The ECB still sees inflation expectations "firmly anchored" in line with the bank's aim of "keeping inflation rates below, but close to 2%." The important first paragraph of the statement also repeated that monetary analysis confirms the "assessment of low inflationary pressures over the medium term." Against this backdrop, the ECB expects price stability to be maintained over the medium term. The statement was little changed from last month and confirms that the ECB remains cautiously optimistic on the outlook in an environment of moderate inflation pressures.

Uneven First Quarter

On economic developments, the ECB stressed that the economy stabilized in the second half of last year with the help of "the ongoing recovery in the world economy, the significant macroeconomic stimulus provided, and the measures adopted to restore the functioning of the banking system." The central bank, however, noted the downward revision to fourth-quarter gross domestic product growth to 0.0%, from 0.1% reported initially, and stressed that while data suggest that the recovery continued in the first quarter this year, it may have been affected by a number of special factors, including adverse weather conditions.

"As a consequence, euro area real GDP growth is likely to have remained uneven around the turn of the year, making it advisable to look through the quarterly volatility and to compare growth developments on a half-yearly basis," the ECB said.

The ECB continues to see moderate growth this year, with the risks to the outlook judged to be broadly balanced. Downside risks continue to relate to "a stronger or more protracted than expected negative feedback loop between the real economy and the financial sector, renewed increases in oil and other commodity prices, and the intensification of protectionist pressures, as well as the possibility of a disorderly correction of global imbalances."

Accelerating Inflation

Like last month, the central bank also noted "renewed tension in some financial market segments." Upside risks include a stronger-than-expected pickup in confidence as well as in both the global economy and foreign trade and larger-than-anticipated effects stemming from the "extensive macroeconomic stimulus being provided and from other policy measures taken."

On inflation, Trichet noted the year-over-year acceleration in the harmonized index of consumer prices, or HICP, to 1.5% in March from 0.9% in February. Without a breakdown, the ECB suggested that this "higher than expected outcome may be related in particular to the energy component as well as food prices, possibly partly as a result of the weather conditions." Looking ahead, the ECB still expects inflation to remain moderate over the relevant policy horizon. In line with "a slow recovery in domestic and foreign demand, overall price, cost and wage developments are expected to stay subdued." At the same time, inflation expectations remain firmly anchored.

There were no signs that the ECB is seeing a serious risk of a major credit crunch in the euro zone, and it seems the central bank still attributes the slowdown in loan growth to subdued demand and debt restructuring, rather than supply constraints. It once again called on banks to strengthen their capital base and take account of government support measures. This will become increasingly important as the ECB phases out its emergency measures, which will hit banks' ability to access central bank funding.

Handwringing Over Greece

The main statement was little changed from last month, and if anything marginally more cautious, on the growth outlook, with a marginally higher outlook on inflation. Even more than previously, the central bank is calling for fiscal stability and measures to reduce budget deficits, which is hardly surprising considering ongoing doubts about Greece.

Indeed, Greece dominated the press conference that followed the policy announcement. The ECB confirmed that it will maintain its relaxed collateral rules into next year, which means the risk has been reduced that Greece debt may become ineligible for the central bank's refinancing operations if Moody's follows other credit rating agencies and downgrades government debt. However, the central bank will implement a system of graded "haircuts" to lower-rated debt, which will make it more expensive to use Greek debt as collateral and could potentially push up interest rates.

Trichet was extensively quizzed on the ECB's position on the IMF involvement in the Greek rescue deal, and he stressed that he never argued against any IMF involvement—just against a deal that relied solely on the IMF. What Trichet could not clarify was the level of interest rates that would be applied to emergency loans to Greece. Trichet stressed that there would be no rate subsidy but added that it would be up to governments to clarify if that means lending at refinancing costs—i.e. roughly average euro zone yields or Greek market rates. If loans were provided at market rates for Greece, it is questionable what the advantage of the rescue package over market financing would be.

Cloudy British Politics

The Bank of England, meanwhile, left both its asset purchase target and the repo rate steady, at £200 billion and 0.50%, respectively, as expected. Markets have been nervous over the past month amid a fragile economic outlook, political uncertainties ahead of this spring's election, and doubts about the government's ability to rein in the budget deficit.

Although we do not expect the central bank to carry out any further asset purchases, the BoE is still far from starting monetary tightening, lagging behind the Fed and the ECB on beginning to formulate exit strategies. Indeed, the BoE has not fully closed the door to further asset purchasing but has said it will keep the asset purchase program under review, and should the outlook warrant it, further purchases could follow in the future.

The BoE appears set to keep monetary policy loose for an extended period. Should the next Parliament choose to tighten fiscal policy more than the government set out in the March budget (which is expected by the Conservatives), the central bank could operate a looser monetary policy without jeopardizing its inflation target. We look for a first BoE rate hike in the fourth quarter of 2010 and a yearend repo rate of 1.00%. We do not, however, expect the asset purchase target to be upped further, beyond the £200 billion that has been bought so far, nor does it appear likely that the BoE will start to reverse its quantitative easing already this year.