ECB Cuts Rates by 50 Basis Points, More to Come

Daily Forex Fundamentals | Written by KBC Bank | Nov 07 08 08:43 GMT |

... ECB cuts for the second time in less than a month ... Rates to fall again in December as new forecasts will emphasise worrying scale of eco slowdown. ...Changed reality of much poorer global growth and continuing credit market turmoil argue for aggressive ECB easing. We think interest rates can fall to 2% in 2009 and possibly lower Lower rates will offer some much needed support to the Irish economy. ...Aggressive ECB policy to fight credit crisis and meltdown As the European Central Bank had effectively preannounced today's rate cut, most market interest focussed on (1) the size of the rate reduction and (2) any pointers as to future policy easing. On a day when the Bank of England delivered a dramatic 150 basis point reduction and the Swiss National Bank also surprised by announcing an intermeeting cut of 50 basis points, today's ECB rate cut of 50 basis points may seem disappointing. Mr. Trichet did indicate that the ECB Governing Council had considered a 75 basis point reduction and also hinted that rates would fall again in December by saying that he ‘didn't exclude that rates could fall again'. By emphasising that the December policy meeting was ‘an important rendezvous' because of the availability of new ECB staff Economic projections, Mr. Trichet is clearly holding out the prospect of a further rate cut next month. Why not cut by more? We think there are at least three reasons why the ECB did not implement a bolder rate cut today. First of all, it appears at least some at the ECB still harbour residual concerns about the inflation outlook. In our comment on the coordinated rate cut of October 8, we highlighted the ECB's continuing and seemingly misplaced concern about ‘second round effects in price and wage setting'. While Mr. Trichet acknowledged today that there has been ‘a further alleviation of upside risks to price stability', the opening paragraph of the press statement also suggests the ECB believes ‘they have not disappeared completely'. This may reflect some differences of thinking within the Governing Council. It could also be that the ECB might be excessively concerned about the looming high profile pay deal in the German engineering sector. Some at the ECB may even feel that the global response to the current downturn threatens an eventual if distant rebound in price pressures. However, it is very difficult to square the ECB's lingering worries about inflation with the relevant evidence emerging on the economic outlook of late. A second argument for cutting less today and easing again in December is that it can be delivered next month against the backdrop of new ECB staff projections that will show notably poorer growth prospects and a weaker inflation trajectory. If the ECB had cut more aggressively today, the presentation of dismal forecasts next month without an appropriate policy response might have put the ECB in an uncomfortable situation Mr. Trichet is now in a position to deliver a further Christmas present in the shape of another easing on December 4th. Finally, it remains the case that the ECB has been very slow to recognise the scale of emerging downside risks to the Eurozone economy as well as the spill-over effect of the credit market turmoil on activity in the ‘real' economy. Mr. Trichet emphasised today that circumstances had changed dramatically of late. However, the sharp slowdown evident in a broad range of Eurozone indicators since the middle of the year suggests a marked worsening of economic conditions that predates by some distance any impact from the failure of Lehman's in September. Naively, the ECB seems to have believed that the Eurozone would be insulated from poorer economic conditions outside the single currency area. In addition, the judgement that ECB monetary policy and liquidity policy could be operated in entirely different directions for a prolonged period of time now looks fanciful. The implication of these errors is a slower policy response that may imply poorer Eurozone economic performance in 2009 than might have been the case as well as the possibility that ECB rates may need to fall further than if rates had been reduced earlier and not increased in July. The ECB has fallen behind Today's decision by the ECB to cut policy rates by 50 basis points on the same day that the Bank of England cut rates by a massive 150 basis points underlines the relatively conservative nature of monetary policy in the Eurozone. Diagram 1 shows that since the turmoil in markets began in August 2007, the US Federal Reserve has reduced it's policy rates by 425 basis points, the Bank of England by 275 basis points and the ECB by just 75 basis points(two recent 50 basis point cuts preceded by July's 25 basis point increase). Admittedly, Euro area rates were not initially as high as in these other economic zones but US policy rates are now far lower while UK rates are below their German counterparts for the first time since the middle of 1994. (Higher inflation, stronger growth and the greater importance of borrowing to the UK economy mean that UK policy rates have traditionally been higher than their continental European counterparts). Blow to the Eurozone economy is not nearly as severe as that to either the US and UK but we are now looking at the prospect of a severe global economic downturn that requires a forceful and speedy response. History suggests an aggressive easing is likely Some indication of the potential scale of ECB rate cuts still to come is suggested by Diagram 2. Faced with a sharp slowdown in growth and attendant downward pressure on inflation in 2001-2003, the ECB cut rates aggressively. That easing cycle lasted two years, encompassed 7 rate cuts and a fall in official rates of 275 basis points. Importantly, however, Diagram 2 also clearly shows that in that earlier cycle, the ECB began it's easing process a good deal quicker in the economic downswing. It is also the case that the current slowdown is likely to be a good deal more severe than it's predecessor. Indeed, we now expect Euro area GDP to shrink by around 0.5% in 2009, the first full year decline in GDP since 1993 when activity shrank to 0.8%. Although the starting point for interest rates was notably higher in 1992, the German Bundesbank, effectively the Central Bank that ruled Europe at that time, reduced it's key policy rates by 275 basis points in 1993. These comparisons argue the case for further sharp and speedy rate cuts even after today's move. Because (i) the global economy has been set on a sharply weakening path for some time (ii) evidence of a marked worsening of Eurozone economic conditions has been accumulating since the middle of the year and (iii) the financial market turmoil intensified sharply in September/October, we don't think incremental changes to policy can be justified. The ECB has now cut rates by 100 basis points in less than a month but we think further near term easing is likely. The current episode is more worrisome than the period surrounding the 9/11 terrorist attacks when the ECB reduced rates by 125 basis points in a little over a two month timeframe. As a result, we look for another 50 basis point cut in December and further easing through early 2009 that takes the main ECB refinancing rate down to 2 per cent by the middle of next year. As Diagram 2 indicates, the current economic downturn looks like being a good deal more severe than the slowdown that triggered the drop in ECB rates to 2.00% in 2003. We think the speed and extent to which money markets return to normality and the extent to which governments use fiscal policy to boost activity will determine whether a new all-time low will be seen in ECB rates in 2009. Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.