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LTRO – game changer or not?

The ECB announced its second long-term refinancing operation (LTRO) on Wednesday. The auction led to 800 banks tapping the ECB for EUR 530bn in three year funding at 1%.

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This compares with 523 banks who took up EUR 489bn in December. Meanwhile, Italian bond yields have fallen over the past month, from 7.11% at the end of 2011 to 5.19% at the end of February.

There has been a widespread feeling among market participants that the LTROs have been “game changers”. The question to this writer’s mind is what game has been changed? What has changed for the better is that the debt markets are no longer pricing Italy in particular as an extreme default risk, while banks can rebuild profitability through exposure to sovereign credit. Yet the LTROs have not prevented a tightening in credit standards over the past twelve months and a reduction in outstanding credit. Eurozone M3 growth, at 2.5% y/y remains below levels consistent with price stability – i.e. that deflation risk remains sizeable in the eurozone.

The ECB seems likely to keep policy unchanged until it can convince itself that the threat to the eurozone is deflation rather than mild stagflation.
David Shairp

The important question now is whether the ECB will be tempted to relax its macro policy stance through a reduction in its refi rate this month. At present, the market is pricing in no chance of any easing by the ECB in the near term. The outlook for the eurozone will be influenced by the next set of ECB forecasts on 8 March. The forward indicators now suggest that the eurozone went into mild recession in Q1 and so the December forecast for quarterly growth of 0.3% q/q may soon be revised down to show a negative growth rate. Such an outcome could take the forecast for 2012 overall down, perhaps in the -0.3% to -0.5% range inhabited by the EU and IMF. Yet, the inflation forecast could be raised slightly to the top end of the ECB’s 2% target, or above in 2012, while a sub-2% rate is probably likely for 2013.

Put bluntly, the ECB seems likely to keep policy unchanged until it can convince itself that the threat to the eurozone is deflation rather than mild stagflation.

David Shairp , March 2012

Article also available in : English EN | français FR

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