Trichet May Be Pushed Toward Rate Cut as Banks Fail

By Gabi Thesing and Simon Kennedy

Oct. 2 (Bloomberg) -- European Central Bank President Jean- Claude Trichet's balancing act may be drawing to a close.

With the euro-region sliding toward its first recession, Trichet's ECB is finding it increasingly difficult to fight inflation and at the same time protect its 15-nation economy from the global credit crunch.

The result may be a move toward lower interest rates as financial turmoil damps growth and reduces inflation pressures. The crisis reached new heights in Europe this week, with governments forced to help bail out five banks and credit costs soaring to records.

``The ECB's Governing Council will have had a serious wake- up call in recent days,'' said Juergen Michels, a London-based economist at Citigroup Inc., who expects the bank to cut rates in December. ``The credit crunch has arrived on its doorstep.''

While all 58 economists surveyed by Bloomberg News predict the ECB will leave its benchmark rate at a seven-year high of 4.25 percent today, those at Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co. this week followed Citigroup in predicting a rate cut before the end of the year.

The Frankfurt-based ECB announces today's decision at 1:45 p.m. and Trichet holds a press conference 45 minutes later.

Separation Principle

Since the market turbulence began more than a year ago, Trichet has insisted on a ``clear separation'' between monetary policy and liquidity management. He's flooded frozen markets with cash in a bid to lubricate lending while keeping interest rates focused on curbing the strongest inflation in 16 years.

In doing so, the ECB became the only central bank in the Group of Seven to raise borrowing costs this year. It lifted its benchmark by a quarter point in July after inflation accelerated to 4 percent, twice its 2 percent limit.

That stance is becoming harder to maintain as banks' refusal to lend to each other starts to hurt the economy, threatening to turn the ``trough'' Trichet predicted into a recession.

The economy contracted in the second quarter, unemployment increased to the highest in more than a year in August and the manufacturing, services and retail sectors all shrank for a fourth month in September. Confidence in the economic outlook is the lowest since the slump following the Sept. 11 terrorist attacks in 2001, according to the European Commission.

Sliding Into Recession

Such indicators suggest to David Mackie, chief European economist at JPMorgan, that the economy will shrink an annualized 1 percent in the second half of this year, compared with the ECB's forecast of 0.8 percent expansion. ``The region is sliding into a meaningful recession,'' said Mackie, who now expects the ECB to lower its key rate to 2.75 percent next year.

European governments have helped rescue banks including Fortis and Dexia SA, and the ECB has boosted its lending of euros and dollars following the collapse of Lehman Brothers Holdings Inc. on Sept. 15.

On Sept. 30 alone, it lent banks 15.9 billion euros at the emergency marginal rate, allowed them to deposit a record 102.8 billion in its vaults overnight and auctioned 190 billion euros and $60.7 billion as financial companies refused to interact with each other.

The longer credit remains tight, the greater the risk that elevated borrowing costs will hurt companies and consumers, damping lending further.

Job Losses

Amsterdam-based Akzo Nobel NV, the world's largest maker of paints, this week postponed plans to repurchase 1.6 billion euros ($2.3 billion) of its stock as debt repayments loom. The company plans to cut 3,500 jobs as demand for its products wanes.

If growth weakens, so should inflation, which slowed for a second month in September as oil extended its decline from a July record of $147.27 a barrel. ``Euroland will no longer have an inflation problem come 2009,'' said Erik Nielsen, chief European economist at Goldman Sachs.

Investors have fully priced in a cut in the ECB's key rate to 4 percent by December, Eonia forward contracts show.

Those bets may be premature, said Klaus Baader, chief European economist at Merrill Lynch & Co. He argues lower rates would do little to assist markets, noting that credit costs kept rising in the U.S. even after the Federal Reserve slashed its benchmark rate to 2 percent.

Inflation of 3.6 percent last month is also still outside the ECB's comfort zone, fanning concern at the bank of a wage- price spiral. Germany's IG Metall labor union, representing 3.2 million workers, is seeking the biggest pay increase in 16 years.

Inflation Expectations

The ECB's preferred gauge of five-year inflation expectations today stayed near its August record of 2.7 percent.

``The bank has to be able to point to substantial improvement in price stability before cutting, and that's still extraordinarily hard to do,'' said Baader, who predicts the ECB's key rate will stay at 4.25 percent through 2009.

One way for the ECB to ease market tensions today without sacrificing its inflation focus would be to shift its other lending rates, said Stefan Bielmeier, an economist at Deutsche Bank AG in Frankfurt.

Under that scenario, the ECB would cut the marginal rate it charges banks for emergency overnight funds from 5.25 percent and raise the rate it pays banks on deposits from 3.25 percent.

``That would cement the ECB's position as a European money market clearing house,'' Bielmeier said. ``It could also pave the way for a rate cut next month.''

To contact the reporters on this story: Gabi Thesing in Frankfurt at gthesing@bloomberg.net; Simon Kennedy in Paris at skennedy4@bloomberg.net