Trichet Poised for `Volte Face' Rate Cut as Summit Approaches

By Simon Kennedy

Oct. 3 (Bloomberg) -- Jean-Claude Trichet is poised to execute his first interest-rate cut since becoming European Central Bank president almost five years ago.

Investors yesterday raised bets on a quarter-point rate reduction as early as next month after Trichet said he and the bank's 20 other policy makers debated such a step for the first time since the credit squeeze began.

The shift marks an end to almost three years in which the Frankfurt-based bank cited inflation as its preeminent concern and 14 months of seeking to protect the economy from the financial market turmoil without using monetary policy. A looming recession and five bank bailouts this week have changed the tone in Europe. Trichet and political leaders from the continent's four largest economies are set to hold an emergency summit tomorrow.

``This volte-face from the ECB shows that it has lost complete confidence about the economic outlook and recognizes that an interest-rate cut may now finally be needed,'' said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London.


Trichet's comments came as he and the leaders from Germany, France, Britain and Italy prepare to meet in Paris tomorrow to discuss the crisis. Governments this week bailed out banks including Fortis and Dexia SA. Officials squabbled yesterday over how to respond to the credit crunch with Germany opposing a unified approach and the Netherlands demanding states set aside funds to help troubled banks.

``All authorities have to be up to their responsibilities, particularly in this period,'' Trichet said yesterday.

Changed Analysis

The euro fell to a 13-month low against the dollar and European government bonds surged after Trichet raised the prospect of lowering the key rate from the 4.25 percent it was increased to in July. ``Increasing downside risks'' dog the economic outlook with the result that ``upside risks to price stability have diminished somewhat,'' he said in Frankfurt.

That was a reversal from his analysis of last month that growth was in a temporary ``trough'' and that ``upside risks to price stability prevail.'' Royal Bank of Scotland, Citigroup Inc. and JPMorgan Chase & Co. responded by predicting lower rates when the bank's Governing Council next meets Nov. 6, earlier than they previously anticipated.

Citigroup economist Juergen Michels said the bank may even cut by a half point should markets remain strained and act sooner in concert with foreign counterparts such as the Federal Reserve. JPMorgan's Chief European Economist David Mackie forecast the bank will slash the benchmark to 2.75 percent by the end of 2009.

``The bank threw the door wide open for a rate cut,'' said Holger Schmieding, chief European economist at Bank of America Corp.

Separation Principle

Until now, the ECB has fought the credit crisis by pushing record amounts of dollars and euros into markets in a bid to jump-start lending. Banks are refusing to lend to each other, propelling money-market borrowing rates to record highs. At the same time, the ECB focused monetary policy on combating inflation that's still almost double its 2 percent limit. It raised the key rate to a seven-year high in July.

What changed is that the market turbulence is now roiling the 15-nation economy, pushing it toward the first recession since the single currency was introduced in 1999 and diffusing the inflation threat.

After 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 shrank for a fourth month in September. Oil prices have retreated 35 percent from a July record of $147.27.

``The many concerns about the economy have evidentially caused the bank to reappraise the situation,'' said Joerg Kraemer, chief economist at Commerzbank AG in Frankfurt.

BOE to Cut?

The ECB may not be alone in easing monetary policy in coming weeks. Investors bet the Bank of England will reduce the benchmark bank rate from 5 percent next week and that the Fed will cut by half a percentage point to 1.5 percent by the end of the month.

Still, with inflation at 3.6 percent and Germany's IG Metall labor union demanding the biggest pay raise in 16 years, Societe Generale SA economist James Nixon said ``next month may still be too early for a cut.'' Kraemer agreed the bank may prefer to wait until December when its staff will have updated economic forecasts.

The risk for the economy is that it is too inflexible to be saved from recession by lower borrowing costs, said Julian Callow, chief European economist at Barclays Capital in London.

``The real economy doesn't react all that much to policy easing even in good times, let along when the banking sector is under the biggest stress in post-war history,'' he said.

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net;