FRANKFURT (MNI) – Renewed tensions in inter-bank money markets have
increased the odds that the European Central Bank will reintroduce
longer-term full-allotment liquidity operations, possibly up to 1-year
or longer, at its next rate setting meeting on October 6.

Money market rates rose again Friday amid reports, later denied,
that Greece was contemplating an orderly default involving haircuts to
bond holders of 50%.

Tensions have been compounded in recent days by a warning from the
International Monetary Fund that European banks may need to find a
further E200 billion as a consequence of the debt crisis.

Though European leaders rebuffed the IMF’s finding, investors
nonetheless reacted negatively by dumping bank stocks amid talk of
growing funding difficulties.

With the prospect of a fresh banking crisis threatening to dominate
the IMF/World Bank and G20 meetings in Washington this weekend, global
leaders were quick to issue a statement in which they pledged to prevent
Europe’s sovereign debt crisis from undermining banks and financial

What started as rumours that the ECB might re-introduce its longer
term liquidity operations quickly took on a sharper edge Friday as a
number of ECB officials made clear that was a real possibility.

ECB Council member and Belgian National Bank Governor Luc Coene
told Bloomberg that the central bank “could perfectly do” long-term
refinancing operations again should it see the need.

Then Austrian National Bank Governor Ewald Nowotny said “it might
be advisable to think about re-introducing” 1-year LTROs, though he said
the ECB was not likely to provide liquidity at maturities longer than
that. Even hawkish Bundesbank President Jens Weidmann joined in, saying,
“we have shown in the past that we are ready to offer liquidity to the
market even at longer maturities if necessary.”

The ECB held three full-allotment 1-year operations in 2009, at a
time of severe post-Lehman market stress, and they were widely credited
with helping restore confidence to money markets. The last one was in
December 2009. On more than one occasion already the ECB has
re-introduced six-month LTROs after having stopped them — the most
recent being in early August of this year, when the market tensions
started to escalate again.

Should the ECB launch another 1-year operation at full allotment,
it could intensify the debate over the degree to which it is creating
moral hazard, at a time when its purchase of sovereign bonds is viewed
with suspicion in certain quarters, including by some on the central
bank’s Governing Council.

Though not as divisive as the sovereign bond buying, the ECB’s
maintenance of unlimited allotment refinancing for the past three years
is nonetheless a source of frustration to some Council members who would
have liked to end it already and wean the so-called addicted banks off
of central bank cash.

But it would be hard to argue under current conditions that the ECB
should even think about reducing its liquidity allotments. Arguments are
clearly running the other way, with even somebody as hawkish as Weidmann
— who strongly opposes the bond buys — leaving the door open to more
liquidity measures.

Indeed, speculation has been growing that the ECB might even
contemplate cut its policy interest rates at the October meeting, given
the strongly deteriorating outlook for growth and easing of inflation

On Tuesday, ECB President Jean-Claude Trichet told a Spanish
newspaper that the recent shift in the ECB’s economic outlook was
“significant.” While not signifying an imminent rate cut, his tone did
imply that he has become more than a little concerned by the worsening
economic picture.

Data this week has been pretty bleak, in particular the flash
Eurozone PMIs, which showed activity in the euro area in contraction for
the first time since 2009. French consumer and business confidence, as
well as the Belgian National Bank’s business confidence indicator, all
continued to drop. All of this, along with sharp downward revisions in
all official forecasts, merely confirm what most already know to be the
unpalatable truth.

Though most officials still decline to talk about an outright
recession, ECB Council member Erkki Liikanen, the Bank of Finland
governor, became the first to break that taboo this week, when he warned
that there was a significant recession risk unless political leaders act
quickly to restore confidence.

With inflation risks greatly reduced, the ECB would appear to have
room to cut rates without fear of stoking cost pressures.

In his interview with Bloomberg, Coene left the option of a rate
cut open, saying, “if the data in early October show that things are
worse than we anticipated we will look at the kind of decisions we have
to take for that.”

However, a cut in the refi rate could look like a panic reaction to
the markets, especially after the ECB raised rates twice just earlier
this year. So the council might well take other options first, including
new LTROs.

However, it is also quite possible that by the time the ECB Council
convenes in early October it could be overtaken by events. Should there
be a sharp escalation of the already intensifed crisis, and should
confidence sink even further, it is conceivable the central bank could
be forced to pull out all the stops.

In such circumstances, a cut in the refi and deposit rates plus the
renewal of 1-year LTROs could look like barely enough.

However if markets are able to find some equilibrium in the coming
weeks, then the ECB’s current view of its interest rates as
accommodative would likely keep monetary policy on hold.

–Frankfurt Bureau +49 069 720 142; email:–

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