Merk Commentary
ECB Inflexibly Flexible - A Turning Point for the Euro?

Axel Merk
Merk Hard Currency Fund
Jun 11, 2010

Following the European Central Bank's (ECB) press conference following its monthly meeting, President Trichet's main task was to boost credibility. As Trichet makes abundantly clear, the ECB is "inflexibly attached to price stability." To achieve its goal, however, he could have added the ECB needs to be inflexibly flexible. When quizzed on the ECB bond purchase program, a program that may take the ECB down a slippery road of money printing should it not be properly neutralized, Trichet discussed three elements: the purpose, the design and observation of the program.

• The purpose is to support the markets when the transmission mechanism of monetary policy is not functioning;

• The design is to buy select government bonds while withdrawing liquidity;

• The third phase is to observe the effects on the market.

This sounds simple enough, but raises many questions:

• Asked to clarify how the "functioning of the transmission mechanism of monetary policy" is defined, so that one can assess when this program may be expanded, reduced or eliminated, Trichet said it was obvious to a see a market that is under distress. However, he also said it is not easy to help restore confidence in such a market environment. In plain English, we believe Trichet meant central bankers are only human and look at the same data as everyone else, including risk spreads in government bond and inter-bank lending markets.

• On the design, the ECB has published the total amount purchased as well as the liquidity withdrawn, but has not provided details on exactly what securities were purchased. This lack of transparency is very much intentional, attempting to have an amplified impact on the markets by drawing from central bankers' toolbox of decades ago, where the element of surprise was a key monetary tool. While the design of the policy conducted is not inflationary, we remain critical, as its effectiveness is limited, while the potential damage to the ECB's credibility, if and when the market tests the central bank's commitment to its policy, could be grave. For the time being, interventions in the markets have been rather modest; the associated neutralizations have been implemented.

• The third phase is to observe the market; we call it the ECB being inflexibly flexible. Differently said, should the markets deteriorate yet again, but only then, will the ECB provide additional support to the markets.

In the coming weeks, over €400 billion in longer term funding that the ECB has provided to the banking system will expire. At its meeting today, the ECB announced that fixed-rate, full allocation tenders will take place July 28, August 25 and September 29 of this year. Think of it as an all-you-can-eat fixed price lunch, the preferred support mechanism the ECB has provided to the markets, a support mechanism that addresses any liquidity issues that may be in the markets. The advantage of the ECB approach relative to the Federal Reserve's is that the ECB facilities run out (or can be periodically renewed), providing a more flexible exit strategy than the Fed's approach, which has loaded its balance sheet up with much longer duration mortgage backed securities (MBS). Indeed, part of the challenges the eurozone is facing may well be a result of the early elimination of some of the programs; the ECB has had to re-open these facilities; in contrast, the Fed has, net, not mopped up any significant liquidity as the MBS program has more than superceded any previous facilities.

Such facilities, however, do not address solvency issues; on this topic, Trichet pointed to the great strides that have been made, particularly in Spain, to address solvency issues amongst regional banks with heavy real estate losses. More broadly speaking, Trichet praised initiatives taken on the fiscal side, including the commitment of finance ministers "on the priority of halting and reversing the increase in the debt ratio and welcomes the commitment to take immediate action to that effect." It shall be noted that such actions have indeed been taken with significant budget cuts not only announced, but already passed by the weaker eurozone governments. Just as important as fiscal consolidation are structural reforms; here, Trichet blatantly says, "wage-bargaining should allow wages to adjust appropriately to the competitiveness and unemployment situation." Cost cutting alone won't make the eurozone more competitive; bold announcements have some from select countries, most notably Germany. The coming months will show what reform measures will be implemented.

As a first test of whether the ECB press conference has increased confidence in the markets, it shall be noted that this is the first time the euro rallied both during and in the hours after the meeting. Is this a turning point for the euro? Possibly; incidentally, as the markets start to embrace Europe's approach to the way it deals with its crisis, other currencies, including the Norwegian krone, Australian and Canadian dollars may benefit more as risk-friendly capital comes back into the markets. Ultimately, we agree with Trichet that convincing fiscal and sound monetary policy is the appropriate path for the eurozone, not debt monetization.

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Jun 10, 2010
Axel Merk

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