ECB Surprises and Greece says 'Never Mind'

The ECB surprised the market by cutting the key rates 25 bp.  This was Draghi's first meeting.  With the euro zone economy either in a recession or quickly headed into one, which in turn will help bring inflation off the 3% area, Draghi led the ECB to reversing the rate hike delivered four months ago. Around the same time, the Greek Prime Minister Papandreou told Sky News that there would be no referendum.  

I had expected, along with the consensus, for the ECB to hold off cutting rates.  I had thought Draghi would resist the economic pressure to do so.  He is the first ECB President from a peripheral, highly indebted country.  Headline inflation is running at 3% (Sept).   The ECB staff provides new forecasts of growth and inflation next month and, for the first time, include 2013 forecasts.  This is important because the ECB policy on a forward looking basis.  

Yet he delivered the cut, returning the key rates to where they were before July.  Given the move and subsequent comments, another 25 bp rate cut in likely next month, but of course, like Trichet, Draghi says no pre-commitment.

However, do not be mistaken.  The ECB has not altered its mandate simply because it has a new head.  The ECB has one goal price stability.  The ECB accepts the premise of the Phillips Curve in that it anticipates slower growth/economic contraction to also usher in lower inflation.   This is an important.  

It is also noteworthy that Draghi revealed that last month's decision to keep rates on hold was not unanimous as today's rate cut decision was, but was achieved by consensus.  That means that even last month, before the collapsing PMI and other recessionary data, some on the ECB wanted to cut rates.  The minority then not only become dominant, but every one favored a cut this time.  

This is important too because it illustrates how the ECB is really different from the Federal Reserve.  It is not that the Fed has three mandates (full employment, price stability and stable long term interest rates) and the ECB has one (price stability), because operationally they can and often do lead to the same action.  

It is not that the ECB has a formal inflation target and the Fed an informal one.  After all,  the ECB has missed its inflation target (overshot it) more often than not on an annual basis, with no negative repercussions.  The Bank of England has to write a letter to the Chancellor of the Exchequer to explain when its misses by a certain magnitude.  In actual performance, over the last decade, US headline CPI has surpassed the euro zone's on average by a few tenths of a percentage point.  

It is not that the ECB looks at headline inflation and the Fed looks at core inflation.  Fed officials also cite headline inflation and talks about market instruments linked to headline inflation, and cites surveys, like the University of Michigan's consumer confidence numbers that also expect people their 1 and 5 year (headline) inflation expectations.  

Rather the key difference is the structure.  The Federal Reserve is run by a strong central board of governors. The regional presidents take turns rotating onto the policy making committee (FOMC).  Barring flukes with appointments/resignations/departures, the board of governors has a majority.  At the ECB, the regional presidents make up the majority and easily out number the ECB Board.  

News reports are conflicting, but it does appear that there will be no Greek referendum.  It is not clear that Papandreou will be able to put together a national unity government, which he seemed to suggest was his intent and the referendum proposal was just a ploy to achieve this.  

That said, we are back to where we were at the end of last week.  The Greek government is pushing for greater austerity in the face of weakening public support.  The 50% haircut that the Greek pension funds are going to "voluntarily" accept on their government bond holdings will mean for hardship for more people.  Finance Minister Venizelos still seems to be pushing for a super majority in parliament to approve the new austerity measures and EU deal.  This requires 180 seats of the 300-seat chamber.   Without a national unity government, this still seems to be a high hurdle.  

And even if somehow the Greek government survives and garners support for the EU agreement, then what? The mess with CDS market continues as the sovereign insurance/hedge must be questioned.  Banks still have to raise capital and the decline in share and bond prices, means they will have to raise even more capital. Although European officials do not want them to achieve the new capital requirements through asset sales, it looks increasingly likely that this avenue will have to be explored.  

Time frames and risk appetites/tolerance matters, but on balance, I still think that relief rallies in the euro will prove unsustainable and that the euro is still going to come off into the end of the year.  Reasonable people may differ on the prospects for QE3 in the US and the outcome of the Super-Committee in the US Congress, but Europe's problems continue to seem much more urgent than the US problems.