The one thing worse than a fire in a building is a fire in a building when emergency exits are bolted shut: a panic in the market is exacerbated when liquidity dries up. It appears the European Central Bank (ECB) embraces this view: in today’s press conference by ECB head Trichet, he re-iterated a number of times that non-standard measures are there to permit appropriate transmission of standard measures. In plain English, this means that whatever emergency support is given to the market is a) temporary in nature and b) designed to allow monetary policy and thus economies to function.
Some observers are disappointed that the ECB "only" announced an extension of its full allotment refinancing facilities until Q1/2011. However, that’s incorrect: Trichet went out of his way to state that the ECB will do "whatever it takes" without using those words: the measures taken will be "commensurate to what we observe any time to what we see as disruption." Policy will be "back to functioning normally when we are back to normal functioning." When asked specifically whether the ECB would do whatever it takes, he indicated there is no limit on the the bond purchase program (Securities Market Program, SMP), although he emphasized that any bond purchases are always sterilzed.
By not giving a specific target on the bond purchase program, the ECB is as pragmatic as possible. If the ECB were to have a "bazooka" type of announcement as demanded by some market participants, such a bazooka would be bound to fail as any limit might be tested. Instead, by merely stating the ECB will adjust to the acuteness of the situation, the ECB has the flexibility to choose the water pistol or bazooka, as may be applicable. In our assessment, Trichet feels very strongly that price stability is best maintained by not explicitly threatening with a bazooka.
It’s also apparent that Trichet doesn’t see a quick and easy fix. To restore confidence, governments must show that they mean business. As such, the ECB, in our assessment, is most reluctant to intervene too heavily in the markets, as that would take the pressure off policy makers to follow through with reform.
It’s also worthwhile pointing out that Trichet did not say the risk spreads in the markets are too high. Trichet continues to respect the market, well aware that a small group of economists do not know better than the market as a whole. If peripheral countries want to pay less for their debt, they have to pursue credible policies.
While there were no specific announcements on further monetary easing, Trichet mentioned that the risks had shifted somewhat to the downside with regard to economic growth. We see this also as laying the foundation to justify further intervention in the markets.
In the meantime, there were questions raised about the cost imposed on strong countries, such as Germany, to bail out weaker ones. Without a doubt, there is a price to be paid for solidarity. We assess the dynamics playing out as healthy, even if the process at times creates shockwaves in the markets.
In action beyond the ECB press conference, what we see as very positive is that Southern European countries in particular continue to sell bonds even in this environment. To attract buyers, bonds must be issued during good and bad times, otherwise we may see a replay of what contributed to Greece’s downfall: when bonds are only sold during good times, the buyers of such securities are bound to lose money and lose interest in participating in the next auction. Spain issued bonds today at a high yield, but with very high demand; that’s the sort of activity required to restore order to the markets.
In summary, central banks throughout the world are showing that they will do whatever it takes. It’s just the ECB has a more restrained approach than the Fed; the ECB approach may lead to comparatively weaker economic growth in the short-term, but possibly to more structural reform and a stronger euro.
President and Chief Investment Officer
Merk Investments, Manager of the Merk Funds