Trichet Clears Obstacles to Higher Rates in Stimulus Withdrawal

By John Fraher and Frances Robinson
Dec. 4 (Bloomberg) -- European Central Bank President Jean- Claude Trichet is withdrawing stimulus measures faster than economists anticipated, clearing obstacles to higher interest rates next year.
The ECB’s decision yesterday to end long-term emergency loans and tighten the terms of its final 12-month tender will give greater traction to any rate increases in 2010 should policy makers deem them necessary.
"The ECB chose a quicker exit path," said Laurent Bilke, a former ECB economist now at Nomura International Plc in London. "It’s very difficult not to think it’s the beginning of a tightening process."
The move to tie the rate on the 12-month loans to the ECB’s key rate rather than setting a fixed rate of 1 percent means any increase in the benchmark will also affect banks’ funding costs.
While Trichet said the move doesn’t signal the ECB intends to raise rates, some officials are concerned that leaving borrowing costs at a record low for too long will fuel asset bubbles and faster inflation.
Trichet spoke as Federal Reserve Chairman Ben S. Bernanke promised a "smooth" withdrawal of stimulus in the U.S. as the world’s two biggest economies pull out of recession.
Yesterday’s announcements "put the ECB in a position where it can choose to raise rates if it wants to further down the line," said David Page, an economist at Investec Securities in London. "We’re penciling in a rate rise in the second half of next year."

Economic Recovery

The risk for the ECB is that any indication it could raise rates sooner than the Fed may fuel further gains in the euro and undermine the region’s economic recovery.
Economists had expected the ECB to leave the rate on its 12-month tender fixed at 1 percent, according to a Bloomberg News survey. That would have made any increase in the benchmark rate next year less effective because banks would have had money at 1 percent through the end of 2010.
By setting the rate on the loans to the average of the benchmark rate over the year, "the ECB has made sure that future movements in interest rates will be reflected in banks’
funding costs," said Colin Ellis, an economist at Daiwa Securities SMBC Ltd. in London.
Some members of the ECB’s Governing Council were against indexing the rate, fearing it would fuel market expectations of policy tightening, people familiar with the discussions told Bloomberg last week. Trichet said today the decision was not unanimous, rather reached "by consensus."

‘Strong’ Dollar

The euro traded at $1.5081 at 7:30 p.m. in Frankfurt last night, down from $1.5123 before Trichet spoke. It fell to
$1.5061 after Trichet said it’s "very important" for Europe that the U.S. has a "strong" dollar.
The euro has gained 20 percent against the greenback since mid-February, threatening to slow the region’s recovery by hurting exports. Daimler AG, the world’s second-largest maker of luxury cars, said yesterday it will shift some production to Alabama from Germany as it seeks to benefit from the cheaper dollar.
While the ECB raised its economic outlook, forecasting growth of 0.8 percent next year and 1.2 percent in 2011, it said price pressures remain "subdued." Inflation is expected to average 1.3 percent next year and 1.4 percent in 2011, below the bank’s medium-term goal of just less than 2 percent.

‘No Compelling Argument’

"The new staff growth and inflation forecasts confirm that there is still no compelling argument for hiking rates," said Marco Annunziata, an economist at UniCredit Group in London.
"Trichet was emphatic in noting that the decisions on liquidity simply reflect improving market conditions and in no way signal a prospective hardening of the monetary policy stance."
Still, the ECB is withdrawing its non-standard operations "at a somewhat quicker pace than we had expected," said Julian Callow, an economist at Barclays Capital in London. "In our view, today’s decisions are on the hawkish side."
ECB council member Axel Weber said yesterday it’s a "balancing act" for central banks to withdraw stimulus measures without threatening their economic recoveries.
"We’ve made it clear that we’ll gradually withdraw unconventional measures in the future," Weber, who is also head of Germany’s Bundesbank, told ARD television. "But that doesn’t mean that we won’t use the necessary caution. There’s no need to send a signal on interest rates at the moment."

Normal Refinancing

The changes announced by the ECB nevertheless pave the way for a return to normal refinancing operations, in which the interest rate on its loans is determined by market demand. After the collapse of Lehman Brothers Holdings Inc. in September last year made banks reluctant to lend to each other, the ECB said it would lend them as much cash as they wanted at its benchmark rate.
Money-market rates have dropped, suggesting banks have become less wary of lending to each other. The Eonia overnight rate, the rate European banks charge each other for overnight loans, has declined to 0.34 percent from 2.2 percent at the start of the year.
"Once liquidity conditions normalize in the third quarter of next year, the Eonia rate is likely to move back to the refinancing rate," said Nick Kounis, chief European economist at Fortis Bank Nederland NV in Amsterdam.
"This would pave the way for conventional monetary tightening from the autumn of next year, and we expect 50 basis points of rate hikes by the end of 2010."