Trichet Extends ECB Power, May Cut Rates at Fastest Pace Ever

By John Fraher

Nov. 3 (Bloomberg) -- Jean-Claude Trichet is extending the European Central Bank's powers just as it gears up for what may be the fastest round of interest-rate cuts in its 10-year history.

President Trichet has pushed the central bank's reach into the euro region's neighboring economies as they struggle to cope with the financial crisis, and has approved record lending to banks. Economists predict the ECB will slash its benchmark rate, currently at 3.75 percent, to 2.5 percent by April after reducing it for the second time in a month on Nov. 6.

``The ECB is at times playing the role of lender of last resort for the whole European financial system,'' said Guillaume Menuet, a senior European economist at Merrill Lynch & Co. in London. ``Its mandate is being implicitly expanded.''

While Trichet's remit applies just to the 15-nation euro region, the absence of an institution charged with financial stability across the 27-member European Union created a vacuum the ECB is trying to fill. In the past three weeks alone, it gave a 5 billion-euro ($6.4 billion) loan to Hungary, set up currency swaps with Denmark and Switzerland and increased its lending to euro-region banks to more than $1 trillion.

Hungarian Prime Minister Ferenc Gyurcsany said on Oct. 28 he's lobbying EU leaders to allow the ECB to provide liquidity outside the euro area. ECB Executive Board member Lorenzo Bini Smaghi said on Oct. 31 the bank stands ready to help ``other'' eastern European countries that are ``asking for our help.''

The Hungarian, Polish and Czech stock indexes all fell more than 24 percent last month.

`Major Danger'

Economists expect more rate cuts from the ECB as it tries to cushion an economy hurtling toward a recession.

The central bank will probably cut its key rate by a half point this week, taking it to 3.25 percent, according to the median of 50 forecasts in a Bloomberg News survey. It will deliver another 75 basis points of easing in the following five months.

Consumer and executive confidence in the euro region's economic outlook plunged by the most since at least 1985 in October, the European Commission said Oct. 30.

``The ECB is only too well aware that extended, deep recession is now the major danger facing the euro-zone economies,'' said Howard Archer, chief European economist at IHS Global Insight in London.

The Bank of England will probably also cut its benchmark by 50 basis points, taking it to 4 percent, according to a separate survey.

Market Strains

Trichet and other policy makers are still trying to ease strains in financial markets that are crippling the global economy. Europe's corporate debt markets endured their worst month on record in October and the gap between the yields on 10- year German and Italian government bonds widened to 1.27 percent on Oct. 31, the most since 1997.

The ECB has responded by ramping up lending to cash- strapped banks, offering unlimited funds. The central bank said on Oct. 21 that lending to financial institutions jumped to a record, surging 68 percent from the first week of September.

That may create problems for the ECB as the risk of possible collateral losses grows, says Natacha Valla, a former ECB economist and now at Goldman Sachs Group Inc. in Paris.

``They have challenges for the future in having a balance sheet of unprecedented size,'' said Valla. ``The have to know how to deal with such a balance sheet, how much capital they have to hold, what it means for risk management. There is a whole set of questions that now have to be answered.''

Not Alone

The ECB isn't the only European institution trying to guarantee financial stability. The EU said on Oct. 29 it's ready to contribute 6.5 billion euros to an International Monetary Fund-led rescue package for Hungary, and European governments coordinated efforts last month to shore up the region's banking system.

Still, some economists and politicians say the ECB's pivotal position at the heart of the financial system should be more formally recognized.

Hungary's Gyurcsany said on Oct. 28 he wants EU leaders to allow the ECB to accept local government bonds as collateral for foreign-currency swaps, saying ``it is extremely important from Poland to Hungary to have these repo facilities in place.''

``My dream is that the ECB gets a financial stability mandate, which is not the case so far,'' said Valla. ``The ECB really has demonstrated it can fulfill such a mandate.''

To contact the reporter on this story: John Fraher in London at jfraher@bloomberg.net