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Preparing for the ECB

Written by A Forex View From Afar on Wednesday, January 14, 2009

On Thursday, the financial markets await the ECB’s reply to the credit crunch. Currently, most estimates run for a 50 basis points rate cut, down to 2.00%.

Earlier this month, the financial markets speculated that, the ECB would vote for a hold decision. This happened after Mr. Trichet said in a public speech that the recent rate cuts would still need time to be felt in the real economy. Usually, monetary policy needs between 6-18 months until they are fully passed on to the real economy.

However, some members of the Governing Council hinted that the bank would cut in January, but it is essentially to take actions in sectors other than monetary policy, where there is more room for maneuvers, especially fiscal policy. The comments of the Governing Council over the last few months indicate that the bank is reluctant to reduce the overnight rates too low, because of the broad implications in the financial markets, particularly in the inter-banking system. This was also underlined by Mr. Trichet by saying that the Fed and the ECB face different shocks, which require different solutions.

Mr. Trichet might hint during the press conference that the ECB will wait for additional data before taking a decision. If so, the euro will certainly rise. However, if there are no clear indications what the ECB might do next, and the Governing Council puts empathy on the risk to downside, the euro will take another strong hit. Using the Bundesbank model, the ECB is committed to prepare the market for its future actions (anchor expectations), and thus it might give important hints about future monetary policy actions..

This tactic was used a number of times during Mr. Trichet press conferences. This can be seen in the strong reactions the euro had to some conferences, while at others the euro simply traded in a tight channel, as in the attached chart. This was mostly seen in the last few months, when Mr. Trichet downgraded its assessment for the Euro-area economy.

ECB Interest Rate and the currency reaction

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