ECB SPURNS IMF WITH EARLY EXIT STRATEGY / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

ECB spurns IMF with early exit strategy

Published: November 29 2009 17:51

If you are a slow mover, you start early. That will be the European Central Bank’s leitmotif as it presses ahead this week with plans to unwind exceptional measures taken to combat the economic crisis.

The Frankfurt-based ECB will leave its main interest rate unchanged at 1 per cent. However, although anxious to avoid drama, expected policy tweaks will underline its determination to implement a timely “exit strategy” and return gradually to something akin to its pre-crisis way of controlling interest rates and providing liquidity.

In doing so it will put itself at odds with the International Monetary Fund, whose managing director, Dominique Strauss-Kahn, has urged policymakers to err “on the side of caution, as exiting too early is costlier than exiting too late”.

Events in Dubai have re-awoken fears of global instability. But the ECB believes the opposite to the IMF – that acting too late is as dangerous as acting too early, if not more so.

Lorenzo Bini Smaghi, an ECB executive board member, argued earlier this month that “the ‘err on the side of being late’ paradigm is potentially as dangerous as the ‘productivity growth’ paradigm of the late 1990s and the ‘fear of deflation’ paradigm of the early 2000s, which led some advanced economies to implement policy stimuli for too long, sowing the seeds of the subsequent crisis”.

A significant fear is of asset price bubbles emerging in Asian countries, which are ahead of the eurozone and US in the economic cycle. One risk is that the ECB, acting faster than the US Federal Reserve, hits exporters by sending the euro higher.

Hours after Thursday’s ECB meeting, Ben Bernanke, the Fed chairman, will speak in Washington at a hearing on his reappointment – increasing the need for Jean-Claude Trichet, the ECB president, to calibrate his message carefully.

So far Mr Trichet has been cautious about eurozone growth prospects. Continental Europe’s worst recession since the 1930s ended in the third quarter, when eurozone gross domestic product rose 0.4 per cent. But the disruption in Dubai has underlined the fragility of economic confidence globally, and eurozone growth was in any case expected to remain anaemic well into 2010.

The ECB’s exit strategy reflects both a return to more normal conditions in financial markets and worries that some eurozone banks are becoming dependent on emergency liquidity provided since Lehman Brothers collapsed in September 2008. Since then the ECB has been matching in full banks’ demand for liquidity for periods of up to 12 months.

In June, banks borrowed €442bn ($662bn, £401bn) in one-year loans – the largest sum ever injected in a single ECB operation. That has ensured that liquidity will remain abundant in the system until at least mid-2010. As part of what economists dubbed “easing by stealth”, it also drove down overnight market interest rates, which are significantly lower than the main policy rate of 1 per cent.

The ECB will not signal a revolution on Thursday and is in no hurry to bring overnight rates back up to the main policy rate’s level. But Miguel Fernández Ordóñez, the Bank of Spain’s governor, told the Financial Times this month that “if you want to be gradualist, you have to anticipate”.

Mr Trichet is expected to confirm that another auction of unlimited one-year liquidity in late December will be the last. Still to be decided is whether also to charge a higher interest rate than 1 per cent, or index the interest rate to changes in the main policy rate. Doing so might be seen as a monetary policy tightening step, although the ECB would probably deny that was its intention.

The ECB is expected to continue for some time to match in full banks’ demand for liquidity in its regular weekly operations. But the level of demand for one-year liquidity in December will, in turn, influence demand for three and six-month liquidity offered in 2010. Mr Trichet may also say this week how those operations will work in future. One option would be to test financial market reaction to a return to a bidding system for some such operations – which would mark another step back towards the pre-crisis regime.

Copyright The Financial Times Limited 2009.