The euro area economy and the financial markets

As you are well aware, in July and early August, a series of events led to an intensification of the tensions in the US sub-prime mortgage market and a sharp decline in the degree of risk appetite of global investors. Market volatility increased across almost all financial asset classes. Stock prices declined as investors sold equities and moved funds into safe-haven investment assets, such as government bonds. In this context, several investment funds holding asset-backed securities suspended withdrawals from their clients. At the same time, a number of European banks made public their direct or indirect exposures to the US mortgage market, particularly to its sub-prime component. These exposures were sometimes sizeable but in most cases not as significant as to threaten the banks’ solvency. In addition, several banks, in particular in Europe, were rumoured to have suffered severe losses stemming from exposures to mortgage-backed securities.

In the money markets the impact of the turmoil was initially felt mainly in the longer-dated unsecured interbank market and in non-government repurchase agreement (repo) transactions: trading in these two segments became increasingly thin. These frictions eventually spilled over to the very short-term money markets, i.e. below one-week. At first, European banks encountered difficulties in raising short-term liquidity in the US dollar market. However, early in the morning of Thursday 9 August, the tensions suddenly spread to the short-term euro money market and to other money markets, such as those related to the British pound and the Swiss franc. The tensions were also felt in the foreign exchange swap market, which is very important for banks managing liquidity in different currencies. Turnover in this market, which had already declined significantly, especially for the longer maturities, came almost to a standstill on 9 August when it was for a while almost impossible to generate USD liquidity via EUR/USD FX swaps.

Following the rapid gathering of market intelligence and contacts with central banks in order to assess the seriousness of the situation, and after concluding that there was the imminent risk of a severe impairment of the functioning of the euro money market, the ECB released a communication stating its awareness of the situation and its readiness to contribute to orderly conditions in the euro money market. It subsequently stepped in to provide liquidity to the market by conducting a first fine-tuning operation (FTO) with an overnight maturity aiming to lend funds to commercial banks against eligible collateral. The operation was conducted as a fixed rate tender at 4.0% and with pre-announced full allotment. ^[2] The main reason for choosing this allotment specification was that, unlike in normal circumstances, the ECB was not in the position to estimate the liquidity needs of the banking sector. The chosen tender procedure, with its demand-driven allotment determination, allowed counterparties to reveal their liquidity needs. In addition, the fixed-rate tender procedure was chosen in order to reduce the risk of erratic bid rates at a time of turmoil. The ECB eventually allotted the full bid amount of €95 billion and overnight rates traded again close to its reference policy rate.

In the morning of the 10 August, bid-offer spreads for the overnight rate were still wide as many counterparties continued to hoard part of their euro liquidity in order to swap it into US dollar later in the day. The ECB again conducted a fine-tuning operation, though this time with a variable rate tender procedure. ^[3] The switch to a variable rate tender on 10 August was largely driven by the desire to control better the allotted amount and avoid an excessive provision of liquidity. The same reasoning prevailed also in the fine-tuning operations on 13 and 14 August in which the ECB was able to reduce the amount of liquidity provided to the market, while maintaining the marginal rate of the two operations close to the minimum bid rates in the previous two main refinancing operations (MRO).

Although most of the attention was focussed on the amount of additional liquidity injected via fine-tuning operations, the following MRO allotment - which was abundant (an allotment of €73.5 billion above the benchmark) ^[4] - succeeded in stabilising shortest-term interest rates and avoided the necessity of conducting further fine-tuning operations during the week.

The subsequent MRO allotments were aimed at gradually reabsorbing banks’ accumulated reserve surpluses by the end of the maintenance period on 11 September.

As the activity in the term money market – particularly, in unsecured lending among banks – remained limited, the ECB satisfied some demand for diversified funding from banks by conducting a supplementary longer term refinancing operation (LTRO) for €40 billion. The operation aimed at indirectly supporting the normalisation in the functioning of the euro money market. Liquidity in the term money markets however continued to be limited. The Governing Council of the ECB thus decided a second supplementary LTRO (€75 billion) on 12 September to reconfirm its commitment to supporting the smooth functioning of the euro money market.

The supply of liquidity provided in the last MRO of the maintenance period ending on 11 September (€5 billion above benchmark) turned out to underestimate the demand for liquidity. As a result, the overnight rate rose again up to 60 basis points above the minimum bid rate. After a further FTO on 6 September (€42.2 billion), the overnight rate started to trade below the ECB policy rate and on the last day of the MP the ECB successfully drained €60 billion of excess liquidity.

All in all, it should be emphasised that over the entire maintenance period we did not provide more liquidity than in earlier maintenance periods. As usual, the ECB’s total liquidity provision over the period is just matching the banking sectors’ liquidity demand, which is mainly driven by reserve requirements. The main difference compared to earlier maintenance periods is the time path of liquidity provision: by providing more liquidity than usual early in the maintenance period, banks were able to build up liquidity buffers, which were reduced later on. These buffers allowed banks to cope better with the increased uncertainty in markets during the turmoil, and as a result, movements in short-term interest rates remained contained. At the same time, a shift in the maturity composition took place, with the increased weight of the 3-month refinancing operations relative to 1-week operations.

Let me stress the technical nature of the ECB’s actions during the crisis. When I talk about liquidity, I mean a very special and narrow concept of it, namely banks’ current account holdings with the central bank. The operations undertaken by the ECB during the turmoil affect the time path and level of those accounts. This is very different from and should not be confused with the concepts of money used in monetary theory, i.e. monetary aggregates such as M3, which measure the amount of money available to the entire economy. Those concepts, which are the ones relevant for price developments in the long run, are not affected by the ECB’s recent operations.

In the maintenance period ending on 9 October, we continued to provide ample liquidity. In particular, the supplementary LTRO allotted on 12 September continued to contribute to maintaining a liquidity surplus, which led to some temporary pressure downward on the overnight interest rate. With the settlement of the following MRO, the ECB started to reabsorb some of the excess liquidity. Although the allotment in this week’s MRO was still €33 billion above the benchmark, the marginal and weighted average rates came out higher at 4.27% and 4.29% and shortest term interest rates increased to levels around 4.30-4.40%, reflecting a stronger than usual end-of-quarter effect. In the final MRO of the maintenance period on 2 October, the marginal rate declined to 4.14%. While notably below the marginal rate recorded in the MRO on 25 September, the outcome of the latest MRO confirmed the existence of upward pressure on tender rates. Overnight rates remained below the minimum bid rate throughout the last week of the maintenance period, and only reverted to levels on average close to the minimum bid rate on the last day of the maintenance period, when the ECB conducted a fine-tuning operation to absorb the excess liquidity in the market.

In the course of our interventions over the last few weeks, a key objective of ours has been to support the smooth and orderly functioning of the euro money market. At the beginning of this week we announced that we will continue to closely monitor liquidity conditions and aim at further reducing the volatility of very short term rates around the MRO minimum bid rate. For this purpose, we will reinforce our policy of allocating more liquidity than the benchmark amount in main refinancing operations to accommodate the demand of counterparties to fulfil reserve requirements early within the maintenance period. The difference between the allotted and the benchmark amount is envisaged to decline gradually in the course of the maintenance period, taking into account the prevailing market conditions. At the same time, we will still aim at balanced liquidity conditions at the end of the maintenance period. We will steer liquidity towards more balanced conditions also during the maintenance period, in a way which is consistent with the objective to keep very short term rates close to the minimum bid rate. And we have announced that we will follow this policy for as long as needed.

Consistent with this policy, on 9 October at the first MRO of the current maintenance period we allocated €40 billion above the benchmark in order to facilitate the frontloading of the liquidity needs of the banking sector. While the marginal rate declined slightly to 4.12%, the weighted average rate remained stable at 4.16%. The communication together with the allotment decision was well received by market participants, and contributed to a decline of 2 to 3 basis points in cash and very short term EONIA swap markets. On October 10, the first day of the new maintenance period, the overnight rate quoted at 4.00%, implying that the allotment amount chosen matched well the banking sector’s liquidity needs. At the same time, longer-term segments of the money market continue to show some signs of improvement in that spreads reduce (for instance, the spread between the Euribor rate and the EONIA swap rate is now 25 basis points for the 1-month maturity, and 66 basis points for the 3-months maturity).

Let me now turn to the main issues that characterise the nature and dimension of the current market developments.

Although the ECB interventions have had a stabilising effect on the euro money market rates at the shorter end of the term structure and, more generally, the money market has recovered some of the lost ground, market participants continue to report limited trading activity, in particular in unsecured interbank term markets. Compared to the situation prior to the tensions, unsecured deposit rates beyond one week are in some cases (i.e. three months) still significantly higher, while turnover remains lower. This situation reflects two main factors.

As regards the funding markets most affected by the turmoil, anecdotal evidence and bilateral contacts with market participants indicate some welcome improvements:

The exchange of information and views between the Eurosystem and other central banks has worked smoothly following the outbreak of the turmoil. Whenever the need has arisen, multilateral or bilateral exchanges have taken place at all levels: from the operational experts to the executive bodies. In addition, we have gathered market intelligence through frequent and open contacts with market participants, both on a bilateral and multilateral basis (making use of the ECB’s market contact groups in the latter case). The information gathered within the Eurosystem via these various channels has proven decisive in forming a consistent and accurate picture of the state of the markets.

Although the qualitative description of the unfolding events was fairly well understood at a rather early stage, it became also clear that the quantitative information available, at least on the spot, was limited. In particular, only partial answers could be provided to some of the questions that arose at the time: How much maturing asset backed commercial papers would need to be rolled over in US dollar and in euro? To which extent had interbank credit lines been withdrawn? How much additional demand for central bank money did this imply and at which maturities? Was there any change in the use of the various types of assets that are eligible as collateral in Eurosystem refinancing operations or was there any evidence of collateral shortage?

As the information gap was to a large extent filled thanks to contacts with market participants and additional efforts by the Eurosystem staff, we were able to sharpen our understanding of the situation, also from a quantitative point of view. Nevertheless, it became evident that information exchanges could be optimised, particularly among the different categories of public authorities involved.

I would like to draw four preliminary lessons at this point in time:

Through the liquidity operations discussed above, the ECB has decisively contributed to an orderly functioning of the money market, which is one of its key responsibilities. It is worth emphasising, however, that our primary mandate calls for our monetary policy to deliver price stability in the medium term.

The two responsibilities are clearly separated and should not be mixed. This is our concept. By being credible in the delivery of price stability, we ensure that long-run inflationary expectations remain anchored in line with price stability, thereby favouring an environment conducive to economic growth, job creation and well-functioning markets, including financial markets. Anchoring inflationary expectations is all the more important at times of financial market volatility. In turn, through liquidity management, we are able to ensure the orderly functioning of the segment of the money market that we influence. This is a necessary condition for a smooth and effective transmission of the monetary policy stance decided by the Governing Council of the ECB.

Only when kept separate, the fulfilment of these two distinct responsibilities can reinforce each other, to the benefit of both macroeconomic and financial stability.

Against the background of the developments in financial markets over recent weeks, it is important to assess their implications for the outlook for the euro area economy. So far the impact of the financial turmoil on the real economy has been limited. The rise in risk premia in money markets has translated into somewhat higher financing costs, while banks have experienced difficulties in getting access to wholesale funding. In addition, expected losses arising from direct and indirect exposure to structured products may have constrained banks’ balance sheets.

Consistent with these indications, the results of the Bank Lending Survey for the third quarter of 2007 indicate that banks have significantly tightened the credit standards applied to loans and credit lines to enterprises and, to a lesser extent, to households. The tightening in standards seem however to have been more relevant for corporate loans. Should this tightening persist, it may transmit the disturbances in the financial markets to real activity. Nevertheless, the most likely scenario so far is one of gradual normalisation in financial markets conditions and of a relatively moderate impact of the financial turmoil on the economic outlook of the euro area economy, which remains rather favourable.

Indeed, the fundamentals of the euro area economy point to a positive medium-term outlook for economic activity. On the basis of the available hard data, the sustained economic growth experienced in the first half of 2007 continued over the summer, lending support to expectations of rather healthy real GDP growth in the third and fourth quarters of 2007. While financial market volatility appears to have weakened consumer and business confidence in September, these confidence indicators remain above their historical averages and continue to point to ongoing sustained growth during the rest of the year. Looking further ahead, the available forecasts for 2008 confirm a baseline scenario of continuing real GDP growth at around trend potential. Robust global economic activity, driven by the continued strength of emerging market economies, will continue to provide support to euro area exports and investment. Moreover, consumption growth should rise gradually, as employment conditions are expected to continue improving, while sustained corporate earnings and profitability should pave the way for robust investment activity.

Nevertheless, the prevailing balance of risks to growth lie on the downside. These downside risks relate mainly to the following factors: (1) the potential for a broader impact from the ongoing reappraisal of risk in financial markets on confidence and financing conditions, (2) concerns about protectionist pressures, (3) possible disorderly developments owing to global imbalances, and (4) further oil and commodity price rises. In particular, financial market volatility and the reappraisal of risk seen in recent weeks have added to the uncertainty surrounding the outlook for euro area economic growth.

As regards price developments, the annual HICP inflation rate for the euro area increased strongly in September 2007 (to 2.1%) and is expected to remain significantly above 2% in the remaining months of 2007 and in early 2008, mainly as a result of adverse base effects arising from past developments in energy prices. Looking forward, inflation is expected to average around 2% in 2008, largely as a consequence of capacity constraints and relatively tight labour market conditions.

In addition, the risks to this unfavourable outlook for inflation remain on the upside. These risks include the possibility of further increases in the prices of energy and agricultural commodities as well as additional increases in administered prices and indirect taxes beyond those announced thus far. In addition, in the context of tight labour markets and favourable economic growth, wage developments may grow at a faster pace than expected, while an increase in the pricing power in product market segments with low competition could materialise.

Our overall assessment is that the outlook for price stability over the medium term remains subject to upside risks. As required by our primary objective, this implies that our monetary policy must stand ready to counter the upside risks to price stability. At the same time, given the heightened level of uncertainty surrounding the outlook for the euro area economy, additional information is needed before further conclusions for monetary policy can be drawn. This is why at the meeting of the ECB’s Governing Council on 4 October we decided to leave the key policy rates unchanged.