Some positives but ECB set to keep rates low

As expected, the ECB left its interest rate policy unchanged at its August meeting last week, with the main refi rate remaining at 0.5%.

No discussion took place on cutting interest rates, but there was a unanimous decision by the governing council to confirm its forward guidance of the previous month.

In July, the council provided forward guidance on interest rate policy for the first time, stating that it expects the key ECB interest rates to “remain at present or lower levels for an extended period of time”.

From a monetary policy perspective, the council retains an easing bias, emphasised by the forward guidance that rates are set to remain at present or lower levels for quite some time.

However, after last week’s meeting, this bias appears to be weaker, given the fact there was no discussion this month on cutting interest rates further.

The weaker easing bias is also reflected in the fact that the ECB has taken on board the improving trends in macro data in recent months, noting that it tentatively confirms their expectation of a ‘stabilisation in economic activity’.

The prospect of another rate cut will depend on how the economy evolves over the coming months and if it deviates from expectations for a modest recovery in activity.

The eurozone economy faltered badly over the course of 2011, with the economy going back into recession in the final quarter of the year. It continued to contract right throughout 2012, with a particularly sharp fall in output in the final quarter of last year.

The eurozone economy contracted again in the opening quarter of this year. The pace of GDP decline, though, did moderate, with output shrinking by 0.3% after its 0.6% fall in final quarter 2012. This mainly reflected a stabilisation in consumer spending, which was flat after five consecutive quarterly declines.

This is a double-dip recession, after the very severe recession of 2008-09. It has seen the unemployment rate, which had stabilised at around 10% in 2010, rise steeply over the past two years to above 12%.

However, in recent months, economic conditions in the eurozone have shown some encouraging signs of improvement.

Industrial production was up by 1.1% in the three months to May, over the previous three month period, while the uptrend in unemployment levelled off during the second quarter.

Leading indicators of economic activity showed continued signs of improvement in July, building on the encouraging indications from May and June. The eurozone’s composite PMI, a good activity indicator, increased to 50.4 in July, representing the first time in 18 months that the index was above the key 50 level.

Another important lead indicator of activity, the EC’s economic sentiment index, has also picked up in recent months, reaching its highest level in July since Apr 2012. Meanwhile, the key German Ifo and French INSEE business sentiment indices have been on a rising trend also in recent months.

The rising trend in the various leading indicators suggests that the economy could return to growth in the second half of 2013. Indeed, eurozone GDP figures for the second quarter, due next week, could well show that the economy stabilised in the quarter.

Nonetheless, GDP still looks set to contract by around 0.5% for 2013 as a whole, for the second year in a row. Modest growth of around 1% is expected in 2014, which would do little to dent the very high level of unemployment.

With inflation also expected to remain subdued, it is little wonder the ECB is guiding that it expects interest rates to stay at or below their current exceptionally low levels for the foreseeable future.

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