TRICHET FACES FED DILEMMA / THE FINANCIAL TIMES ( RECOMMENDED READING )

Trichet faces Fed dilemma

By Ralph Atkins in Frankfurt

Published: October 3 2010 17:29 |

The European Central Bank could clash over strategy with the US Federal Reserve this week as a sharp fall in banks’ demand for its liquidity and evidence that the eurozone’s recovery remains on track strengthen the case for unwinding exceptional economic stimulus measures.


Jean-Claude Trichet, ECB president, faces a communication challenge after Thursday’s meeting to set interest rates. Amid talk in the US and UK of further “quantitative easing” to boost the economy, a harder tone from the ECB would risk sending the euro higher, hitting the region’s exports. Eurozone economic news has been dominated recently by the costs of rescuing Ireland’s banking system and Portugal’s struggle to bring its public finances back under control.


Less noticed last week was a clear display of confidence returning elsewhere in the eurozone. The region’s banks rolled over just €133bn ($183bn) out of €225bn in three-month to 12-month ECB loans that expired last Thursday. With the flood of money that the ECB has pumped into the financial system since the collapse of Lehman Brothers retreating, market interest rates jumped backed close to the ECB’s main policy rate of 1 per cent.


Mr Trichet is likely to interpret that market reaction as positive and boosting the prospects of credit markets oiling the wheels of the economic recovery. Eurozone growth slowed in the third quarter but remained positive and few economists predict a “double-dip” back into recession. The ECB sees scant risk of deflation.


Barring upsets, the ECB in December will consider further the next steps in its “exit strategy”. For the past two years, it has been meeting in full banks’ demands for liquidity. But it has already phased out offers of such liquidity for six-month and 12-month periods.


Marco Annunziata, chief economist at UniCredit, said: “The ECB might again feel the moral responsibility and break ranks to exercise leadership, indicating that the gradual and cautious normalisation will continue, and that further QE at this stage would be excessive and potentially risky.”


Leaving too much liquidity in the system for too long could sow the seeds of the next crisis, Mario Draghi, Italy’s central bank governor, warned on Friday. But he added that the ECB had to be “extra careful” and the real economy “has improved but remains fragile”. The danger for the ECB is that rising market interest rates and a stronger euro in effect tighten monetary policy – which could fuel speculation it may yet have to cut the main policy rate below the record low of 1 per cent.


Analysts expect the ECB to remain firm, however. Jörg Krämer, chief economist at Commerzbank in Frankfurt, said: “It would required extraordinarily negative surprises on the economic front for the ECB to cut interest rates.” Although eurozone growth rates remained sub-par, they were"enough for the ECB to move gradually to the exit,” he said.


On Friday, the Eonia three month average overnight interest rate, which measures the cost that banks charge each other to lend, increased to 72 basis points – a jump of 19 basis points over the week and the biggest weekly jump this year. The euro was at a six month high against the dollar.


Copyright The Financial Times Limited 2010.