By Johanna Treeck

FRANKFURT (MNI) – The European Central Bank is likely to leave
interest rates unchanged Thursday and reveal little about potential
future exit moves, as weak banks and trouble in the periphery continue
to hold policymakers hostage.

The surprising resilience of the Eurozone’s economy and
unexpectedly weak demand in ECB liquidity operations have sparked
speculation about a resumption of the exit strategy at the start of next
year and early indications of such moves later this week.

Similar developments lead to the same speculation ahead of last
month’s Governing Council meeting only to see the ECB extend its
unlimited liquidity provisions, with the exception of indexing 3-month
operations to the average rate of the MROs over the life of the
respective LTROs — a move that should have little practical effect,
since the MROs are fixed at the refinancing rate, which is almost
unanimously expected to remain unchanged at 1% well into 2011.

While the central bank insists that it makes policy for the
Eurozone as a whole, exit moves no longer appear to be guided by ongoing
improvements in the broader markets but rather by funding constraints
among a declining but systemically relevant number of banks heavily
concentrated in the Eurozone’s periphery.

With no ready solution for this problem, betting on further
unwinding of non-conventional policy support in early 2011 may yet be
premature. With fixed-rate, full-allotment operations fully scheduled
until year-end, President Trichet is unlikely to drop any hints at this
point regarding future withdrawal of the ECB’s crisis-generated
liquidity provisions.

With regard to the government bond purchasing program, the ECB just
stepped up intervention last week to the highest level since early July,
buying 10 times more than the previous week. Ireland’s escalating
banking crisis served as a stark reminder that the sovereign debt crisis
can flare up again at any time and the ECB is not about to abandon its
sole instrument for countering these tensions any time soon.

Ongoing improvements in the Eurozone as whole, however, should not
go unnoticed in Thursday’s introductory statement. While the economic
and inflation assessments should remain largely unchanged, the monetary
analysis may sound somewhat more upbeat and Trichet may welcome the
ongoing decline in ECB liquidity demand.

Developments in the Eurozone have remained in line with the ECB’s
scenario of ongoing but slowing growth in the second half, allowing
Trichet to confirm the previous assessment of a moderate recovery ahead
and moderate inflation over the policy-relevant horizon. However, given
darkening clouds on the global level and fresh sovereign debt jitters,
the outlook should continued to be characterized as uncertain.

The return to positive territory of corporate lending in August
should allow the Council to draft a more optimistic paragraph on
monetary developments. But given monthly volatilities, the statement is
unlikely to confirm Executive Board member Juergen Stark’s assessment of
a turning point just yet.

Perhaps the most significant development since the last monetary
policy meeting is the much smaller-than-expected rollover of the E225
billion expiry of 3-month, 6-month and 12-month ECB funding, which
resulted in a large reduction of liquidity and significantly higher
EONIA rates.

Trichet should welcome the drop of liquidity demand as a sign of
improving money market conditions. As in August’s press conference, the
ECB president will likely refrain from either welcoming or condemning
higher rates, saying instead that it is a function of banks’ own
decisions. In the same vein, he will probably insist that rising EONIA
rates should in no way be read as a monetary policy signal.

Given improving market conditions and a potential turnaround in
credit, it is hardly surprising that some Council members have called
for exit measures in the first quarter, since too much liquidity could
result both in future inflation and misallocation of assets.

In this context, last month’s decision to index the rates of
3-month tenders in the final quarter is key, since it appears to be a
concession to Council hawks who are pressing for further exit moves. The
next step might be to return to competitive bidding in the first quarter
on the longer term operations, as called for by Bundesbank President
Axel Weber and some fellow hawks.

However, many Council members still think that as long as weak
banks in the periphery and elsewhere still depend on the ECB as a
lifeline, it is too dangerous to pull the plug.

The central bank has pressured governments to ensure that banks
will get back onto their feet and regain market access, but so far to
little avail. Even if they press ahead with recapitalization efforts, it
will likely take some time and is not likely to be completed within the
first quarter.

The Council is mulling its own alternatives. Mario Draghi was
reported to have said that the Council was talking about ways to limit
peripheral bank borrowing from the ECB. A senior Eurosystem source told
Market News Weber and some other Council members wanted to increase the
on Irish and Greek bonds in order to cap the volume of funds that Irish
and Greek banks could borrow from the ECB.

But there is some resistance to this proposal, since it could hurt
precisely those economies that are most in need of ECB support and at
risk of speculative market attacks. In exploring alternatives, the
Council must still forge a consensus and might not be ready to rush down
new avenues, especially while the sovereign debt crisis continues to
smolder.

With Japan embarking on a new round of easing measures earlier this
week and the US Federal Reserve appearing on the verge of doing the
same, European policymakers may also want to refrain from further exit
steps that could subject the already-soaring euro to yet more upward
pressure, thereby hitting Eurozone exporters. And in the absence of any
significant inflation pressures, there’s appears to be no pressing
reason for the ECB to be rushing towards the exit.

The hawks on the Council are no doubt stepping up pressure to press
ahead with exit moves in the first quarter, and it is possible that they
may yet be successful. However, the chances that they will win the
debate during this Thursday’s policy meeting — particularly in the
absence of a fireproof solution for still ailing banks — appear to be
miniscule.

–Frankfurt newsroom +49 69 72 01 42; Email: jtreeck@marketnews.com

[TOPICS: MT$$$$,M$$EC$,M$X$$$,M$$CR$,MGX$$$]