• Inflation is still near its peak and......

• ...the hard eco data have not yet confirmed the deterioration in sentiment.

• The EMU Summit details need to be specified and implemented....

• ...while of critical importance the incoming new president cannot sow …doubts about continuity of the stability-oriented of the ECB...

• Therefore, no new decisions on policy, but the door for policy easing.....

• ... will remain wide open.

The ECB meeting on Thursday will be watched very closely because it will set out the ECB response to the EMU Summit decisions. It will put the new ECB president under the spotlight at a time when credibility is seen as very important. However, we don’t think it will bring any significant new policy measures.

In September, the ECB downgraded its risk assessments to economic growth and inflation to respective downward and neutral. It effectively meant that its tightening cycle was at least interrupted. In October, it went further. It took a range of decisions on the non-standard policy measures, in particular by launching a new 40 billion euro covered bond purchase programme, by prolonging the full allotment fixed rate procedure on its MRO, one-month STRO and 3-month LTRO’s till mid 2012 and by re-introducing 2 oneyear LTRO’s of which the first has been done last week. The ECB left its main re-financing rate unchanged at 1.5%. It however did no longer qualify the monetary policy stance as accommodative and Trichet during the press conference admitted that the Governing Council had considered both keeping rates unchanged and lowering them. From his answers at the press conference, it was obvious that some members were in favour of cutting.

interest rates. However, Trichet stressed a few times not to underestimate the importance of the non-standard measures that were taken. So, one could eventually argue that the ECB didn’t want to take the attention away from these non-standard measures to support the financial system by cutting rates at the same meeting. So, the legitimate question is whether they will cut rates at this week’s meeting.

After considering all elements, we think the ECB will keep rates unchanged in November, as the timing for a lowering of rates is just not right yet. Economic risks may be still more on the downside, even if the outlook on global growth may have improved somewhat or as some would say hasn’t deteriorated as expected. However, inflation is still at its peak and real interest rates are significantly negative. The EMU Summit has just passed, but many crucial details are still to be decided. The ECB may be more comfortable to act on rates when more time has passed since the Summit. It keeps policymakers under more pressure to finish the job, while it underlines the independance of the ECB. Indeed, cutting rates so short after the Summit might leave the impression that the ECB has been bullied into such a decsion.

Critically, it will be the first meeting of the incoming new president, Mr. Draghi. In such case, it is important to signal continuity. If the ECB would cut rates without the fulfillment of all the usual conditions, it might harm the credibility of the ECB and its president. It would suggest the ECB under Draghi would take a new direction that is less stability-oriented, one of the hallmarks of the ECB since its birth in 1999. It might at a difficult time raise nervousness in Germany and some other countries, which may hurt instead of accommodate the search for solutions in the euro debt crisis.

Credibility is of the essence for a Central Bank. In this respect, the conditions for a rate cut may be more obvious in December when inflation might have started to turn downward and the Q3 GDP and new ECB staff projections would make clear that 2012 economic growth and inflation will still be lower than projected in September. We briefly review each of the above arguments somewhat more in depth.

Inflation still at top, while growth data slightly weaker

In October, inflation stabilized at 3% Y/Y, the cycle peak. Core inflation increased in September (latest figure) again to 1.6% Y/Y, from 1.2% Y/Y in August, matching the cycle peak. Core inflation bottomed in January 2010 at 0.8% Y/Y. Forwardlooking price indicators have turned down, espeespecially firms selling expectations in the EU Commission survey. The index fell in October to 5.0 from 6.9 in September and from its peak of 24 in March. The index is near its average. The less reliable consumer sentiment price outlook index fell in October to 24, still above average (21.2) and only slightly below its cyclical peak of 30.8.

Inflation expectations are still well contained. The 10-year inflation swap stands at 2%, virtually unchanged from where it stood at the October ECB, while the forward 5-year/5- year inflation expectations climbed to 2.16%, up about 20 bps since the previous meeting, but still in well-established “safe” territory. M3 money supply figures accelerated further in September, while loans to non-financials picked up. However, monetary condition remains subdued.

Regarding eco data, the PMI business sentiment for October showed a further deterioration. The headline, composite, index stands at 47.2, near levels that traditionally divide boom and bust. However, the EU Commission economic confidence survey showed a better picture. Sentiment broadly stabilized in October and at a level that is still above levels that signalled recessions in the past.

While the sentiment indicators are flashing red, the ECB may want confirmation of the hard data before changing rates. Until today, only Belgium Q3 GDP has been published. It was flat on the the quarter. However, it is a far too narrow basis to draw conclusions for EMU. On November 15 the EMU and other national GDP data will be released, giving ECB a better take on the economy when they meet in December. The industrial production figures for July and August were strong and even if September is flat, production would be up 1.46% on the quarter. Regarding the global economy, some improvement was noticed especially in the US that performed well in Q3 and at the start of Q4, while also Chinese business sentiment turned again higher in October. However, the improvement certainly needs confirmation before becoming more optimistic.

The Q3 ECB bank lending survey was downbeat and pointed to possible further slowing of the economy. Banks tightened credit standards substantially for both firms and households (with the exception of consumer credit). Banks registered also a slowing in demand for all categories. On top of it both credit standards and loan demand is expected to be respectively tighter and lower in the fourth quarter.

In the past, the ECB reacted more often to economic data than to inflation data, which isn’t of course unusual for a forward-looking central bank, as growth developments lead inflation. So, quite often inflation was still above 2% when the ECB started to cut rates (cf. Graph). However, one shouldn’t jump too fast to the conclusion that a rate cut is baked in the cake, due to the growth slowdown and recession risk. In the ECB mindset, official interest rates below the 2% inflation target are to be avoided in “normal” times, as very low rates are considered as potentially dangerous for a healthy longerterm development of the economy and financial markets.

The graph shows all interest rate increases (green) and all interest rate cuts since the start of the ECB in 1999. The vertical axis shows the CPI value one month before a rate change and the horizontal axis contains the PMI value. Regarding rate cuts these invariable occurred when the PMI was 50 or lower. The inflation was less of a factor. Cuts occurred even twice at a time inflation topped 3%. Regarding rate hikes, most were decided when the PMI was above 55, even when inflation was still well below 2% Y/Y. That shows that growth considerations matter more than actual inflation. PMI’s above 55 are associated with strong growth.

The graph shows three blunt exceptions to the “rules”, each time when rates were raised when the PMI’s were below 55, once even below 50. The July 2008 rate increase was an isolated one that occurred when the financial crisis was already well entrenched. It was the time of the oil price surge and HICP inflation amounted to 4%. The rate increase was largely considered as a mistake in economic circles. The March 2005 and July 2011 rate increase also occurred when the PMI was below 55. In both cases, the increases happened from rock bottom rates (respectively 2% and 1.25%) and suggest that indeed the ECB is at unease to keep rates at these very low rates.

The current PMI at 47 and inflation at 3% Y/Y) certainly fall within the conditions that allowed the ECB to cut rates in the past. However, other arguments, like the very low level of rates (see higher) and developments (changing of the guard (see lower) makes us think the ECB will not lower rates at this meeting.

Change of the guard

It will be the first ECB meeting under its new president, Mr. Draghi. The latter is already since 2006 member of the Governing council (as president of the Bank of Italy) and is president of the Financial Stability Board. Of course, Mr. Draghi will over time put his mark on the institution, just like Mr. Duisenberg and Trichet did. However, the ECB is a stabilityoriented institution that doesn’t want to be too activist, even if it showed during the crisis that it can act fast and bold. It is a relatively new institution that has to cope with various sensibilities inside the EMU. This was for instance very clear in the final speeches Mr. Trichet gave in which he defended the ECB’s track record by putting forward its outstanding record on inflation and in which he tried to convince the critical German audience that the ECB had always stayed within its mandate to maintain price stability, also in a very demanding and changing environment since the crisis broke out in the summer of 2007. Mr. Trichet (http://www.ecb.int/press/key/date/2011/html/sp 111024.en.html) said that these demanding circumstances led to debates (e.g. on non-standard measures like bond buying), “but only on policies, not about principles, because in the euro area our principles do not change. Our principles are the foundations on which we rest. Stability. Responsability. Independence.” These speeches show who well Mr. Trichet knew he had to stick to a stability-oriented monetary policy. One should expect a similar attitude of Mr. Draghi. No haste, no adventures. No revolution, but evolution. This is the main reason why we expect Mr. Draghi to personify continuity and thus start his tenure by keeping the line set out by Mr. Trichet. He will lead the ECB in responding to new challenges, but within a strict stabilty-oriented framework that is acceptable for the paymasters of the EMU.

There is a lot of pressure on the ECB to continue the SMP and some even advocate that the ECB should be bolder and act as the unlimited buyer of last ressort in the government bond markets. On the former, Mr. Draghi already suggested he will continue the SMP, but clearly only to the extent needed to improve a failed monetary transmission mechanism, not to bail-out profligate governments. The lukewarm intervention of the ECB in the Italian bond market last Friday (post EMU Summit) suggests that the ECB might still not be convinced by the will of the Italian and maybe the other governments to tackle without restraint the current problems inside EMU. We hope to get more on that from Mr. Draghi. Anyway, the effects of the buying will be neutralized by sterilizing the money injection. For those who think Mr. Draghi’s ECB will easily follow the Fed, BoE and BoJ into unsterilizedbond buying, we refer to an October 21 speech of Mr. Gonzalez-Paramo. (http://www.ecb.int/press/key/date/2011/html/ sp111021_1.en.html )

“At various points of the financial crisis, including the present juncture, financial stability has been at risk. What does this mean for the ECB in practice? As laid down by the Treaty, there is a lexicographic ordering of objectives: price stability comes first: if this is granted, then the ECB may contribute to financial stability. Therefore, there can be no question of trading off price stability against financial stability. Indeed, price stability is a necessary condition for financial stability and thus the best contribution monetary policy can make to financial stability.

Note, however, that even with pricestability guaranteed, the ECB should only contribute to the smooth functioning of the financial system. Financial stability is a responsibility of governments, while our responsibility is price-stability. Indeed, if governments respond appropriately to risks to financial stability and banks reinforce and efficiently restructure their balance sheets, the ECB may have to be less concerned with nonstandard measures to restore the monetary policy transmission mechanism.

So while one should never say never, the ECB still sees its role as guarantor for price stability, while financial stability is a responsability of governments. Is it a coincidence that various ECB members, including the outgoing president come out in public with an unconditional defence of the stability-oriented policy of the ECB? We don’t think it is and don’t count on Mr. Draghi to change things overnight. So unless the financial crisis really explodes and put the euro itself in danger, the ECB will stick to its mandate and we doubt Mr. Draghi will see things differently.

In the run-up to the EMU Summit, German chancellor Merkel objected to a French-inspired sentence in the draft resolution that invited the ECB to continue its SMP programme. Chancellor Merkel didn’t want that political authorities excercised pressure on the ECB. This is an important signal from Germany that shows it has confidence in the new ECB president.

The press conference will be very interesting. We expect Mr. Draghi to show continuity and make clear that he sees no reasons to deviate from the existing course. This, however, also means that he should keep the door for rate cuts open, maybe that he will push the door even a bit further open. Doing differently and cut rates would be a surprise and thus affect markets. Currently, only 6 out of 54 analysts in the Bloomberg survey expect a rate change. Four of them go for a 25 bps cut, while two expect a bolder 50 bps rate cut. It looks too early though.

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