Proper monetary policy a challenge for ECB: UniCredit

Marco Valli, chief Euro Zone Economist, UniCredit, says that the market will not pay much attention on VIX front because having a rate at 0.75 or 0.5, when the monetary policy transmission mechanism does not work properly, that does not make any difference for the economy. What matters is whether the ECB will be able to re-establish proper functioning of the monetary policy transmission mechanism; this is the biggest challenge of the ECB. The official rate is not the main indicator that investors are looking at this stage.

Also read: 10 most frequently asked questions about QE3 Below is the edited transcript of his interview to CNBC-TV18. Q: What are your expectations on what the ECB can and cannot say tomorrow?
A: I think the ECB will not provide of details of bond purchase programme, there are chances that Draghi will stick to his earlier broad message that he delivered in August. We do not expect much details, on the other hand people some from the markets expects more detail, so that may be a reason for some disappointments for them.
Draghi will not explicitly state any kind of cap for either yields or spreads in government bonds while he will confirm the central banks commitment to eliminate that the risk of compatibility which is pricing to the sovereign bond curve of countries like Italy and Spain which is related to the perception that the euro zone could break apart. It is a risk premium which the ECB will not tolerate and they are ready to intervene it to eliminate the risk, but only after governments have formally asked for EFSF support behind the conditionality. Q: How long will the markets be just satisfied with Draghi’s strong talk, will they not want the action and with that action not coming or hinged upon the sovereign governments asking for it, will the market lost its nerve and fall?
A: I think that the market has found a sort of equilibrium but I am not sure if this is a stable equilibrium because it is clear that the ECB will not make the first move, Draghi made it very clear that they expect the governments to act formally for help to commit to the memorandum like reforms and structural changes to the economy and then the ECB can step in. The market is also aware of the fact that the ECB will not make the first move. So, a country like Spain may have to formally ask for EFS support. Q: German's August services PMI stands at 48.3, I think coming into contraction terrain from 50.3 in July, does that mean that there will be more elbowroom given by Germany to the ECB considering that now it is in contraction mode, of course it is services, this is not manufacturing?
A: The recent data out of Germany has been quite disappointing and Germany also is now affected by the problems that we see in the periphery. Germany is an export-led country and therefore most of its goods and services go within the euro zone and the euro zone is not performing, actually it's contracting. Germany is going to suffer and this is exactly what has happened right now.
So this is providing Germany with a clear perception that they cannot decouple and leave the ECB in even mode, though we do not expect them to cut interest rates tomorrow but if current weak economic data in Germany continue then the case for a further rate cut would certainly build-up. Q: What details is the street expecting fro tomorrow’s meeting. What else is the market expecting where the disappointment could come from?
A: I am not sure because we have seen markets moving quite faster on expectation of ECB action. We should not forget that ECB would move only after government's request. I think it's fair that the market has priced out some tail risk because having the ECB which can intervene at the short end of the curve with potential and limited resources certainly eliminate some tail risks in the near term.
However, the market has moved a bit ahead of itself considering that first need to wait for Spain and Italy to formally ask for request before the ECB actually steps in. The market is correcting, pricing out some tail risk. However, the market is bit too strongly considering that the ECB is not yet ready to intervene. Q: If the ECB cuts rates by 25 bps to deal with the disappointment on the bond buying front, do you think the markets will hold on rally or even correct because bond buying is the key focus area right now?
A: The market will not pay much attention to what happens on the VIX front because having a rate at 0.75 or 0.5, when the monetary policy transmission mechanism does not work properly, that does not make any difference for the economy or there is only very marginal difference. What matters is whether the ECB will be able to reestablish proper functioning of the monetary policy transmission mechanism; this is the biggest challenge of the ECB. The official rate is not the main thing that investors are looking at this stage.