The European Central Bank has an exit strategy in mind from extraordinary support measures and will act as soon better growth fuels upward pressure on inflation, policymakers said today.
ECB President Jean-Claude Trichet said the central bank could well raise interest rates before fully withdrawing extra liquidity, if market tensions justified this.
In speeches to an ECB Watchers conference in Frankfurt the day after the ECB held rates at a record low 1.0 per cent, central bankers laid out the framework for the ECB's exit strategy and the trigger points for action.
"Now is not the time to exit. But I would like to make it clear that the ECB has an exit strategy, and we stand ready to put it into action when the appropriate time comes," Mr Trichet said.
Central banks and governments around the world face a tricky task in weaning the economy and financial sector off stimulus without derailing the fledgling economic recovery, and the issue is high on the agenda at Group of 20 meetings starting in London today.
Mr Trichet said the cornerstones of the ECB's exit plan included a link to its monetary policy strategy, which meant any non-standard measures putting pressure on inflation would be unwound immediately, whereas non-inflationary measures could be kept in place for as long as needed.
"(Our) framework permits short-term interest rates to be changed while keeping some non-standard measures in place, should continued credit support be needed," he said.
ECB Executive Board member Juergen Stark said the central bank was alert for signs of a turning point in the economic cycle, which would herald price pressures and spark action.
"Our mandate is to maintain price stability over the medium term," he said. "As soon as upside risks to price stability emerge in a context of an improving macroeconomic environment, it will be time to withdraw the policy stimulus."
Still, Mr Stark said picking the turning point was even more difficult than normal, given uncertainty about the economic outlook and the prospect of lower potential growth rates.
The ECB has flooded markets with extra cash and decided yesterday to lend banks another batch of 12-month funds later this month at a flat rate of 1.0 per cent, lowering the odds of a very strong takeup.
Mr Trichet said central bank liquidity was likely to remain abundant for the time being but noted the usual link between central bank liquidity and money supply - a leading indicator for future inflation - had weakened.
This reflected the fact banks were hoarding liquidity and depositing much of the cash borrowed from the ECB back at the central bank overnight, rather than lending it on.
"The exit strategy, in the end, will need to be invoked at the precise time in which the traditional link between broad money and our provision of liquidity to the banking system will re-establish itself," Mr Trichet said.
"This calls for a constant and careful monitoring of the conditions at which the Eurosystem supplies central bank credit to banks in view of the evolution of the economy and of markets expectations."
Still, Mr Stark said he did not expect an imminent recovery in the credit cycle.
Given expectations of a sluggish climb out of recession in the 16-nation region, it was understandable that lending remained subdued.
Loans to companies were likely to keep contracting into early 2010, Mr Stark said, and historical evidence showed recovery in lending was likely to take nine months after GDP picked up.
The ECB was not ruling out a double-dip recession in the euro zone, he said.
Mr Stark told journalists that upward revisions to ECB staff growth forecasts largely reflected the better-than-expected second quarter of 2009, and the outlook past then was patchy.
"We see a more significant uptick in the very short term. This means that the growth will be very sluggish and we might see over the next quarters an oscillation around the zero line, so in some quarters slightly above zero and in some quarters we cannot exclude that it will turn negative again, in one quarter or maybe two quarters," he said.
"We are cautiously optimistic about the economic outlook, it is very likely that we see economic growth return to positive growth rates earlier than expected but this is mainly driven by temporary factors, in particular fiscal stimulus."
"The key question is whether the improvement we have seen recently ... is really sustainable, and against this backdrop we are cautiously optimistic."
Mr Stark said he saw no sign of deflation, and inflation risks were balanced over the medium term.
Reuters