Konjunktur Shadow ECB Council discusses the timing and sequencing of the exit from very loose financing conditions

In preparation of their monthly meeting members of the Shadow ECB Council discuss when the ECB should start to withdraw monetary stimulus and whether rates or rather liquidity provision should be tightened first. Latest comment by: Jacques Cailloux

Elga Bartsch

My bias beyond the upcoming meeting is a neutral one as far as policy rates go. But I believe that we should start to map out the exit from the non-conventional measures. I think the December one-year tender should be granted without a spread. But I would like to see a roadmap for the exit from the ECB?s generous term-funding. Instead of an abrupt discontinuation of the supplementary LTROs, a return to partial allotment either under a fixed rate tender or a variable tender could be more advisable. Here I see some advantages of using a fixed rate tender with partial allotment as an intermediate step before going to a variable rate tender, notably the firmer control the ECB has over the interest rate at which the refi operation settles. In order to give banks enough lead-time to wean themselves of the ECB?s liquidity drip when it comes to fund lower quality assets, it could also make sense to set out a longer-term plan for a gradual narrowing of the collateral pool beyond 2010. Taking into account the possibility that money market tensions might rise again once the ECB starts to raise rates I would be in favour of leaving the MROs on the current fixed rate tenders with full allotment for some time. If needed, we could decide to bring the EONIA overnight rate closer to the refi rate again by reverse refi operations ahead of the first official rate hike.
(Elga Bartsch is Chief European Economist of Morgan Stanley in London)

Charles Wyplosz

Most signs point toward the end of the recession. The signs are somehow weak, however, with good news in some countries (e.g. Germany) and less good ones in others (France, Spain). If output is unlikely to fall, the speed of the recovery is currently unknown. Domestic inflationary pressure is therefore unlikely over the policy horizon (one year for me), especially as employment is usually lagging output, which means that wages should remain subdued for an extended period of time. Anyway, when policy changes, I would start by reducing liquidity. It has already come down but much remains to be done. Liquidity currently held by banks should be used to trigger credit expansion, so it should be withdrawn when credit picks up speed. This is fairly straightforward to monitor. It is only when the ECB's balance sheet will have returned to normal size, and when we are reassured that banks can operate without a lifeline, that the phase of interest rate rises should be initiated.
(Charles Wyplosz teaches economics at the Graduate Institute of International Economics in Geneva)

Thomas Mayer

The one-year refi will be stopped after this December. I expect the economy to continue to strengthen and growth to average 1.6% next year. Inflation is likely to average 1.1%. Against this background, non-standard measures should be gradually phased out, beginning with the one-year refi, which should be offered in December for the last time (at unchanged conditions). In the course of the first half of 2010 I would expect the longer-term refis to be moved gradually to variable rate refis (starting with the 6-month, followed by the 3-month operation) and, as a result of haircuts at the allocation, the longer-term refi rate to gradually rise. Moreover, I would also expect a return to normal bidding and allocation procedures for the main refi operation, with the minimum-bid refi rate kept at 1% until about mid-year. As a result, I would expect EONIA to edge up towards the main refi rate. From a persent perspective, I could see the need to start rasing the main refi rate as of mid-2010, with a total increase in this rate of no mone than 100bp during the second half of 2010. Thus, at the end of 2010, I would see the monetary policy stance as being still very easy (refi rate of 2%), but no longer as easy as during the emergency conditions of 2008/09.
(Thomas Mayer is Co-Head of Global Economic Research of Deutsche Bank in London)

Angel Ubide

I think the ECB should start sending a clear message that the current situation of unlimited liquidity supply will end soon. Banks and governments must realize that they need to solve the banking problem with capital and restructuring measures, and the central banks should not put itself in a position of having to finance the reflation of the banks' balance sheets. There are technical issues involved in how to proceed and it should be done in a gradual fashion, but the direction should be clear. The lesson from Japan is clear: only when the FSA decided to adopt a tough stance with the banks and forced recapitalization and restructuring plans did the Japanese banking sector, and with it the economy, returned to some normalcy. I also think that the ECB should make clear that it will return as soon as possible to a stance where the eonia rate matches the policy rate. The current situation is confusing and non transparent and, although it may have been useful during the crisis period, it is no longer warranted. As far as rates, it should be a decision independent of the provision of liquidity. The outlook for inflation is still one where the risks seem to be tilted to the downside, and where inflation next year could be closer to one than to two percent, and thus there is little reason to change the current message of rates on hold for a long while.
(Angel Ubide is Chief-Economist of Tudor Investment Corp. in Washington)

Marco Annunziata

With some signs of recovery in both economic activity and financial markets, I also believe it is time to map and launch an exit strategy from the exceptional liquidity provisions. Unwinding the liquidity stimulus is going to be more difficult than putting it in place: it needs to be done gradually, with clear communication to the markets, and closely monitoring the impact. “Last in, first out” is probably a good rule of thumb, so I think the ECB would be right to discontinue the 12-month LTRO after December. The second step, to be implemented during Q1, should be to switch the other LTROs to a fixed amount; this will inevitably bring more volatility in quantities and/or rates bid—I would favor holding the operations at variable rate to get more information on the prevailing price of liquidity. I would favor maintaining a fixed rate/full allotment procedure until Q2. As the strategy unfolds I believe we need to closely watch two things: first, the reaction of EONIA rates; and second, the differential impact across the banking system. Some banks are still heavily dependent on ECB liquidity, while others have gained more normal market access—the ECB will need to monitor stress on individual institutions, and ideally the competent governments will stand ready to intervene as needed. This is a crucial sensitive point: if part of the banking system is still impaired, as liquidity is drained the stress will emerge; unless this stress is dealt with quickly, there is a risk of undermining market sentiment. Second, as liquidity is drained, short term market rates should gradually move up towards the Refi—although this may not happen very quickly especially if the take up at December’s 12 month LTRO is substantial. The speed of this convergence can be influenced (for example by raising the depo rate or using reverse repos), but the ECB should bear in mind that this will mean exiting the ZIRP, being equivalent to a traditional hike in policy rates, so this will also require watching the inflation and growth developments closely.
(Marco Annunziata is Chief Economist of Unicredit in London)

Gustav Horn

The sequence of an exit strategy is in my view quite clear. First liquidity has to be reduced by reverse open market operations. As soon as the EONIA is close to refi rate, The ECB should assess the situation again. If there is still a self sustaining recovery, the ECB could start with small steps to higher rates. The other way round makes no sense since anybody then still has access to cheaper liquidity. There is a general caveat. The ECB has to be very careful before starting to tighten its course. A too early tightening risks a severe return to recession.
Gustav Horn is Scientific Director of IMK institute in Düsseldorf

Jacques Cailloux

There are increasing signs that the interbak situation has improved significantly and perhaps to the extent that some normalisation in the provision of central bank liquidity is warranted. With the improvement in the funding situation of the banking sector much more advanced than that of the economy, it makes sense that the sequence of exit should take this into consideration. The ECB should however remain prudent as it starts adjusting the current modus operendum of liquidity provisions and keep some flexibility in its decisions. In particular, should the ECB decide to reduce the number of liquidity operations next year, it should state clearly that it stands ready to return to the unconditional provision of liquidity that was prevalent during the crisis, should tensions reemerge in the interbank market.
(Jacques Cailloux is European Chief Economist of RBS in London)

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