The European Central Bank is poised to start phasing out the extraordinary liquidity measures it set up over the last couple of years when it concludes its last rate-setting meeting of the year on Thursday.
Analysts expect a number of significant decisions and announcements from the central bank for the 16 countries that share the euro — even though the benchmark rate will likely stay at the record low of 1 percent for months to come.
In particular, they will be looking to see what President Jean-Claude Trichet says in his press conference about liquidity measures introduced to keep the banking system from collapse and to limit the scale of recession.
Trichet has voiced worries that banks may be getting addicted to the central bank's cheap short-term money loans — suggesting he favors a gradual withdrawal of the measures to help the financial sector wean itself off central bank support.
Following comments from fellow policymakers in recent weeks, after official figures showed the recession in the eurozone has ended, Trichet is expected to confirm that December's one-year money offering will be the last.
Trichet is also expected to unveil details of how the ECB will provide liquidity to banks next year and how it eventually plans to phase out other, shorter loan programs.
The outlook for these measures is important because despite the end of the recession, Europe's banks remain reluctant to lend to each other as well as to households and businesses.
The European Central Bank is not expected to be too hasty in implementing its exit strategy. After all, the recession continues in countries like Spain, where unemployment stands at a startling 19.3 percent.
Dubai's debt debacle has added to the sense of unease in the markets and posed renewed questions about the sustainability of the global economic recovery by elevating sovereign credit risks to the forefront.
The cost of insuring against default by heavily indebted countries like Greece has risen, for example.
"As a result, the ECB is likely to err on the side of caution for now," said Frederik Ducrozet, eurozone economist at Calyon Credit Agricole.
"Gradualism should prevail when it comes to scaling back liquidity provision," he added.
Moreover, analysts stressed that whatever the ECB plans to do in the coming months, there will be ample liquidity for a while yet and that interest rate rises are not on the agenda just yet.
In that context, ECB staff forecasts, also due on Thursday, will also be closely watched. Given the eurozone's return to growth in the third quarter and a higher than expected increase in November's inflation rate to 0.6 percent, the markets are expecting a fairly substantial increase in the growth and inflation forecasts for 2010 and 2011.
Even so, the pace of recovery — the consensus in the markets is for growth next year to be revised up to 1 percent from the previous estimate of 0.2 percent — will still pale in comparison with the amount of output that was lost during the recession. That means inflation is also likely to remain subdued.
Jennifer McKeown, European economist at Capital Economics, thinks the growth forecast may be upgraded to 1.5 percent, but even then she noted that this would be "a weak recovery compared to past standards, implying that spare capacity will persist for quite some time."
Trichet will also likely be quizzed on developments in the currency markets, where the euro last week struck a new 15-month high against the dollar — the worry is that a rising euro could choke off the fledgling recovery in the eurozone.
Trichet has consistently reiterated the Group of Seven's mantra that excessive volatility in exchange rates could damage economic and financial stability.
Even though Trichet is unlikely to make any stronger statements, the markets will be interested to hear what he says about his meetings last week with Chinese officials and his attempt to get the Chinese authorities to let their currency to appreciate against the dollar. The yuan is set artificially low against the dollar by Chinese authorities to keep their exports cheap in U.S. markets — that causes the dollar to weaken against other floating currencies, mainly the euro and the yen.
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