Hesitation Is Lethal

June 11, 2010

The European Central Bank (ECB) needs to ramp up its unorthodox policy support in order to limit the spread of sovereign debt concerns into the broader financial system

The ECB left its key refinancing rate unchanged today at 1%. In the press conference that followed, ECB President Jean-Claude Trichet suggested the risks to the economic outlook and price developments are“broadly balanced”. In fact, he focused much of his statement on reassuring the hawks that the central bank “remains firmly committed to price stability.” In our opinion, deflation is a much greater threat, especially if the central bank moves too slowly to limit contagion within the region. We sympathize with the concern that monetary policy in the euro area is set for the region as a whole and efforts to set interest rates to support the weakest members will over-stimulate the Germany economy. Unfortunately, relatively low trade-openness in the weaker nations means that currency depreciation will provide disproportionate support to the stronger regional members. As a result, the only way to stimulate the Med-4 successfully is to quantitative ease and ramp up asset purchases. The latter has been scaled back in recent weeks but Trichet hinted at further measures today: “[the ECB] has no immediate plans to sell debt certificates to absorb excess liquidity pumped into markets through the bond purchases”. Bottom line: It has always been the case that investors need to watch the ECB’s actions rather than its words. Nonetheless, policy efforts to prevent the debt crisis from spreading and limit the backup in sovereign spreads need to be stepped up. Stay tuned.