ECB interest rate decision (March)

As expected, the European Central Bank decided to leave interest rates unchanged at the current level of 1.0% in March. The interest rates for marginal lending and overnight deposits also remained unchanged at 1.75% and 0.25% respectively.

While the main refinancing interest rate is expected to stay at the current level for an extended period of time - at least until the end of the year - monetary policy tightening is effectively under way as the European Central Bank prepares to withdraw some of the special liquidity measures currently in place. First, liquidity will not be provided for 12 months anymore, but will return to the six month maturity. Secondly, the ECB is likely to reconsider for how much longer to provide full allotment and when to return to the auction process - although this is unlikely to happen in the first half of 2010. Finally, the bank may increase interest rates for overnight deposits and lending - following a similar move by the Federal Reserve.

However, with inflation dropping to 0.9% in February, from 1.0% in January, and predicted to stay well below target, the European Central Bank is unlikely to pursue drastic monetary tightening. Additionally, with output forecasted to rise by only 1.2% over 2010, excess capacity will prevent inflation from coming anywhere close to the two per cent target. Indeed, the European Commission recently downwardly revised its inflation forecast and is now expecting annual inflation of only 0.8% in 2010 compared to 2009.

Despite leaving rates on hold for now, the European Central Bank is putting its foot on the liquidity brake. Changes in the way liquidity is allotted and the prospects of rising short term interest rates should become visible in a gradual rise of market interest rates. However, with the economic prospects in the eurozone far off from electrifying and inflation expectations subdued, the governing council will move very slowly and monetary tightening is unlikely to start in earnest before the turn of the year.