The European Central Bank took its first step toward unwinding its extraordinary support measures for the euro zone economy on Thursday by signaling 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 rest of the central bank's policy of flooding markets with cheap and abundant funds in December.
Allowing one-year lending to expire after the operation scheduled for December 16 would already be a step toward weaning banks off the funds which have pushed money market rates to record lows and helped rekindle credit flows.
Asked whether the ECB was ready to drop its one-year operations, Trichet noted that financial markets were not expecting the ECB to announce more one-year operations next year.
I will say nothing to dispel this present sentiment of the market, he told a news conference. But the decision will be taken by the Governing Council in the next meeting in a month's time.
Trichet stressed that the ECB's liquidity steps -- including lending banks unlimited funds at fixed rates -- would be phased out in a gradual but timely way, but would not continue at the same extent as in the past.
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 a signal of a likely rate rise before the end of 2010.
The ECB has made heavy hints it may not roll out its extraordinary one-year tenders into 2010, said Richard McGuire, RBC Capital Markets fixed income strategist.
The end of such tenders .... bolster expectations the bank will begin to normalize rates next year.
The ECB's stance contrasts with the U.S. Federal Reserve, which made no change to policy settings on Wednesday despite growing confidence in a recovery, and the Bank of England, which left rates untouched but said it would expand its quantitative easing program by 25 billion pounds.
(For graphic of global interest rates see http://graphics.thomsonreuters.com/RNGS/ECO/RATES.jpg )
Germany's Axel Weber had fanned speculation that the ECB might reveal the start of its exit strategy on Thursday when he said last week that the policy of unlimited funds at main liquidity operations should be kept on, while very long-term liquidity operations could go sooner.
Many of the emergency measures brought in to counter the financial crisis run only beyond the end of 2009.
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.
All 78 economists polled by Reuters last week had expected the ECB to leave interest rates at a record low for the sixth month running, with no hike expected until late 2010.
MORE OPTIMISM ON GROWTH
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.
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, recognizing that the outlook remains subject to high uncertainty.
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 again in the coming months and remain moderately positive over the policy-relevant horizon.
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.
The comments sound slightly more optimistic on the growth outlook and confirm our view that the central bank is inching gradually closer to starting its exit strategy from the currently very expansionary policy, said currency strategists at Action Economics.
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.
(Writing by Krista Hughes, editing by Mike Peacock)