UPDATE 5-ECB takes first step towards exit, more due in Dec

Published: 05 Nov 2009 17:26:49 PST

* ECB keeps rates at 1.0 percent for sixth month

* Trichet signals no extension to 12-month operations

* Gives December rendezvous for other non-standard steps

FRANKFURT, Nov 5 - The European Central Bank took its first step towards the exit from its crisis steps on Thursday by signalling one-year loans to banks will not be repeated next year.

The ECB kept its main interest rate on hold at 1 percent for the sixth month in a row and ECB President Jean-Claude Trichet promised to announce a decision on the central bank's cheap and abundant liquidity policy in December.

Its stance contrasts with the U.S. Federal Reserve's promise to keep rates near zero for an extended period and the Bank of England's extension of its quantitative easing programme, although at a slower pace.

However, other central banks, including Australia and Norway, have already raised rates -- a move the ECB is not expected to follow until the end of next year.

Allowing one-year lending to expire after the third such operation scheduled for Dec. 16 would already be a step towards weaning banks off the funds which have pushed money market rates to record lows and helped rekindle credit flows.

Money borrowed at the two previous one-year liquidity operations accounts for 75 percent of the ECB's outstanding loans to banks.

Asked whether the ECB was ready to drop its one-year operations, Trichet noted that financial markets were not expecting the ECB to extend these next year.

"I will say nothing to dispel this present sentiment of the market," he told reporters. "But the decision will be taken by the Governing Council in the next meeting in a month's time."

The euro extended gains against the U.S. dollar as traders increased bets on the ECB soon moving to a formal exit plan, while rate-sensitive bond yields hit session highs.

Trichet said improved market conditions meant that not all the ECB's extra liquidity steps would be needed to the same extent as in the past and said these would be phased out in a "timely and gradual" way.

Many of these, including lending banks unlimited funds at fixed rates, are only guaranteed to continue "beyond the end of 2009".

He declined to say, however, whether the ECB would bump up the price of funds at next month's 12-month operation from the 1.0 percent rate -- a move which would be taken as confirmation of a likely rate rise before the end of 2010.

In an interview with Reuters Television, Trichet showed no rush to bring forward the expiry date of even the longest-lasting measures, such as accepting lower-quality assets as insurance in its lending operations.

"We will examine the situation permanently but I don't see anything that I could preannounce at the moment," he said of the end 2010 expiry-date on lower collateral standards.

BACKDOOR EXIT

Economists said Trichet's comments backed expectations that the ECB would let other extra liquidity operations expire next year and allow market interest rates to drift back up.

"The ECB will opt for the gentle backdoor exit for its non-standard measures, not for an active withdrawal of liquidity, by not extending these 12-months operations in December," ING economist Carsten Brzeski said.

"By simply not extending these measures, the ECB will gently drain liquidity and money market rates should move towards the refi again."

Trichet gave no sign of any rush to drain funds, saying the ECB did not aim to bring overnight cash rates back to the main policy rate in the next period of time.

By next month's meeting, the ECB will have updated staff economic projections and the first forecasts for 2011, the crucial period for today's monetary policy decisions given the long lead time.

Trichet said caution was needed on the economic outlook but said growth rates could turn positive before the end of the year and hinted at room to revise up previous forecasts.

"The latest information continues to signal an improvement in economic activity in the second half of this year," he said.

"The Governing Council expects the euro economy in 2010 to recover at a gradual pace, recognising that the outlook remains subject to high uncertainty."

The European Commission on Tuesday revised up its growth forecast for next year to 0.7 percent and sees an acceleration to 1.5 percent in 2011, after a 4.0 percent fall this year. Euro zone manufacturing activity grew in October for the first time in 17 months and its service sector expanded at its fastest in nearly two years. All this has boosted expectations that the 16-nation bloc returned to growth in the third quarter.

Inflation remained negative in October, at -0.1 percent, but Trichet said this was expected to turn positive in coming months and remain moderately positive over the policy-relevant horizon.

Many politicians see a threat to the recovery in the strength of the euro, which has risen 16 percent against the dollar in the last eight months and about 3.5 percent using the ECB's preferred trade-weighted measure.

Trichet stuck to the Group of Seven line on currency moves, saying excessive volatility had adverse implications and urging China and other emerging Asian nations to allow their currencies to appreciate.