FRANKFURT (MNI) – The European Central Bank may cut interest rates
as soon as next month and might also announce further loosening of its
collateral rules to ensure banks will have continued access to central
bank liquidity.

Comments by Executive Board member Benoit Coeure in an interview
with the Financial Times published late Wednesday clearly suggest the
ECB is gearing up for action.

“Cutting rates is certainly an option as far as our monetary policy
is concerned. It was discussed at the last governing council meeting and
I would expect the next council to discuss it again,” Coeure said. “We
are in a situation where there is no threat to medium-term price
stability.”

Council members Ewald Nowotny and Jozef Makuch had previously
signalled a readiness to cut the main refinancing rate to a historic low
0.75% and the deposit rate to zero.

President Mario Draghi last Friday said there were no inflationary
risks while warning of “increasing downside risks” to the economic
outlook. weak Eurozone’s PMIs for June, released Thursday, further
underscored those risks.

The PMIs showed private sector activity continuing to shrink as
quickly as it did in May, at almost the fastest pace in three years.
After signalling economic contraction for five consecutive months, the
index now shows that economic weakness is spreading from the periphery
to the core and is beginning to hit even the German economic powerhouse.

While a rate cut appears increasingly likely, its remains a matter
of pure speculation. Coeure argued that the impact of a cut would
largely be psychological, which could argue for a more aggressive move.
On the other hand, a 50 basis point cut could stoke possibly unwanted
speculation that the ECB was approaching quantitative easing territory.

Coeure’s comments also suggest that the central bank may not limit
its support measures to lowering borrowing cost. While he dampened
expectations of renewed bond market intervention and of another 3-year
LTRO in the near-term, he did concede that “if needed” the ECB may
further ease collateral rules.

Caught in the negative feedback loop between weak sovereigns and
their banking systems, even solvent banks are running out of eligible
collateral as the debt crisis hits their bonds holdings and deposits.
The ECB been actively discussing various options to address the problem
for many weeks.

Indeed, German weekly Die Welt reported on Wednesday that the
Governing Council had already agreed on a “significant” loosening of
collateral requirements at its mid-month meeting Thursday. According to
the report, the looser rules pertain in particular to mortgage backed
securities and should thus be particularly useful for the Spanish
banking sector.

So far, there has been heavy resistance from the Bundesbank to
weakening collateral for fear of burdening the Eurosystem with ever
greater risks. However, the ECB may be running out of options to get
liquidity to where it is needed. As Coeure pointed out, simply launching
another LTRO would not be useful in addressing the problem.

“The ECB has the crucial role of providing liquidity to sound bank
counterparties in return for adequate collateral…The Eurosystem will
continue to supply liquidity to solvent banks where needed,” Draghi
stressed Friday.

To keep the system afloat, the ECB may simply have to adjust its
definitions of “sound counterparty” or “adequate collateral” once more.
Indeed, it may already have done so.

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

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