Chastened ECB wary of premature monetary tightening

February 12, 2013

–Darren Williams is European Economist at AllianceBernstein. The opinions expressed are his own.–

Cyclical indicators have improved, but the economic and financial backdrop in the euro area remains fragile. The ECB has clearly learned from past mistakes and is keen to avoid a premature tightening of monetary conditions.

Recent survey data suggest that business conditions in the euro-area economy are starting to improve after a steep contraction at the end of 2012. In January, the composite Purchasing Managers’ Index (PMI) for manufacturing and services rose by over one point to 48.6, the highest reading for 10 months. This and other recent data are broadly consistent with our central forecast, which is for a stabilization of the euro area economy in the early part of 2013, followed by a modest recovery thereafter. But there are also a number of reasons for caution.

First, there is an unusually wide divergence in the PMI data between Germany, which appears to be recovering strongly, and France, which seems to be headed for deep recession. The unprecedented size of this gap suggests that the signal from survey data may not be as robust as usual. Second, recent unsettling political developments in Italy and Spain mean that we should not yet rule out a return of financial-market stress. Third, there is still no evidence that the improvement in financial conditions is feeding through to an increase in credit availability. Fourth, the appreciation of the euro represents an important headwind which, if extended, could choke off the nascent recovery.

The European Central Bank seems to share this caution. Indeed, the main message from last week’s monthly press conference was that the economic and financial situation in the euro area is still too fragile for the ECB to allow early tightening. There are two possible worries on the horizon: the euro’s recent rise and the impact that the recent early repayment of funds borrowed in special longer-term refinancing operations (LTROs) might have on interbank interest rates.

At present, the ECB is probably not unduly concerned about either, since it regards them both as being a direct consequence of the recent improvement in investor confidence. But the Bank is clearly not indifferent to them, saying it would take action if the repayment of excess reserves started to put upward pressure on the overnight lending rate. As for the euro, the ECB took the unusual step of listing its rise as a downside risk to price stability. It is clear that, should the euro continue to appreciate, it would affect the outlook for growth and inflation in the euro area, eventually triggering a response from the ECB.

For now, unless there is a significant appreciation of the euro from current levels, or a big relapse in the economy, we continue to think interest rates in the euro area will remain on hold for the foreseeable future. Nonetheless, we take considerable comfort from the more nuanced communication strategy adopted by President Draghi, which suggests that the ECB is learning from past errors. It also shows how much the central bank has changed under its new president and—crucially for the euro area’s recovery hopes—provides confidence that it is less likely to repeat the mistake made in 2011, when it tightened monetary policy prematurely.

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