Will ECB Bow to Widespread Cries for Sharply Lower Rates?

Daily Forex Fundamentals | Written by KBC Bank | Dec 03 08 09:21 GMT |

... Negative economic growth in 2009 and ... ... inflation dropping well into the ECB target area ... ... in a context of a financial crisis and signs that the prospect of a strong, timely and coordinated fiscal policy response is fading... ... will convince the ECB to accelerate its easing policy... ... ECB is at crossroads... At the November ECB press conference, president Trichet used his answer to the first question, asking why the ECB was not more aggressive, to signal that the December ECB meeting would be an important one. He referred to the staff projections that would be available and allow for an occasion to review facts, figures and data before deciding on policy. Clearly, this was intended to signal policy rates would fall again before Christmas. While an ECB rate cut on Thursday is virtually certain, there is significant uncertainty as to how large it might be. ... .Projections to show negative growth in 2009... The dataflow has been horrendous in recent months. While the demise of Lehman brothers in mid-September has altered financial markets thinking dramatically, it appears a pronounced step-down in the ‘real' economy was already underway by the end of the Summer. The most recent figures brought certainly no relief. If anything, they suggest problems are intensifying. The various sentiment surveys, the timeliest reliable indicators for economic activity, were unequivocal in their message: the EMU economy is now in a recession that will be deep and protracted. The EU Commission economic sentiment index (see graph) dropped a historical unprecedented 12.6 points in the last two months to 74.9 and is now close to the bottom reached during the severe 1992/93 recession (73). The index is well below the levels registered during the 2001 recession. In the November 2008 ECB monthly bulletin, the ECB examined the reliability of survey data during periods of financial turmoil. The study concluded that the survey indicators didn't tend to exaggerate swings in activity or give false signals about real economic developments. This research adds to the weight of recent awful EU confidence survey data in current monetary policy debates within the ECB. Official and private forecasters have cut their 2009 growth forecast at a very rapid rate in recent months. The IMF slashed its 2009 forecast to -0.5% from +0.2% in October, while OECD projects a 0.6% crimp before a recovery pushes growth in 2010 to 1.6%. So, it is unlikely the ECB staff projections can come out with a positive growth estimate for 2009. In September, the ECB staff projections still put 2009 growth at 1.2%. So, a negative growth figure now would be a dramatic but necessary revision that reflects a radically changed economic out- look in the past few months. ... and to slash inflation forecast too... In September, the ECB revised up its 2009 inflation forecast to 2.6% from 2.4% in June, but now a larger downward revision seems inevitable. Recent projections by IMF and OECD that are in line with the KBC in-house forecast may once more be a good pointer for the staff projections. The IMF puts 2009 inflation at 1.6% and the OECD at 1.4%, while the latter estimates 2010 inflation at 1.3%. The ECB acknowledged in its November statement that not only would inflation decline in the next months and reach a level in line with price stability during the course of 2009, but warned that even stronger downside movements in HICP could not be excluded around the middle of next year, largely due to base effects. The ECB, noblesse oblige, immediately added that such movement would be short-lived and thus not relevant from a monetary policy environment. Some ECB members even suggested that some months of outright decline in (Y/Y) inflation was possible. Nevertheless, in the current chilly economic climate of contraction, inflation dropping towards zero will affect sentiment and should downside growth risks materialise it won't take long before talk of deflation get ingrained. ... debate in the ECB council nevertheless to be heated... . The ECB has never favoured an activist policy and during the first ten years of its existence preferred a step-bystep approach, within a well-defined framework, that was mostly well communicated in advance to markets. Confidence, predictability and accountability were three cherished characteristics of policy. Other Central Banks have been extremely aggressive, especially in recent months. The Fed started a de facto quantitative monetary policy after it slashed rates drastically in early 2008; the BoE cut its rates by 150 basis points during its November meeting and even the traditionally conservative Swiss National Bank surprised friend and foe by a surprise inter-meeting 100 basis points rate cut in mid November, after having participated in the co-ordinated rate cut earlier that month. After the November ECB meeting, governor Trichet said that the Council had discussed both the option of lowering rates by 50 and by 75 basis points, suggesting that some policymakers already were already in favour of a more aggressive approach at that stage, but after all was said and done, the council unanimously decided it was appropriate to lower rates by 50 basis points. It seems that the issue of how to alter policy in a crisis situation was again discussed at the non-policy meeting of Thursday 20 November. ECB member Mersch warned hours after the meeting was finished that “a large rate cut could be counterproductive and signal the opposite of what we wish to signal, namely certainty and confidence.” He said the central bank has to keep a steady hand on the tiller and provide certainty in a time when many have lost their bearings. Even before that non-policy meeting, voices out of the ECB Executive board stressed the need for a disciplined monetary and fiscal policy. ECB chief economist Stark stressed that monetary and fiscal policy need to remain fully committed to their respective medium term objectives and pleaded for a global financial pact. Acting in disrespect of medium term objectives might lead to a third step in the crisis, namely a crisis of public finances, he concluded. In the same vein, ECB board member Bini Smaghi in a speech on “Restoring confidence” warned that in case the transmission mechanism was impaired, there was a risk that policy action, even when rapid and ample, would not succeed in reversing the trend. That might leave policymakers out of ammunition too early. He suggested it was better to try to restore the transmission mechanism first, as rate cuts have little impact on the real economy as long as the transmission mechanism is impaired. Of course, within the ECB Council, other policymakers are likely to plead for a more aggressive approach, particularly as the most recent data point towards a further acceleration in the deterioration in the Eurozone economy and an associated sharp easing in inflation pressures. As a result, the internal debate on Thursday is likely to be heated. Will the ECB cross the Rubicon and throw far more forceful ammunition in the fight against a deepening economic slump and a sharp disinflation? Markets firmly believed that the ECB will need to signal a radical change in its thinking. Ultimately, we think the ECB will decide to cut rate by 75 basis points. The economy is in a deepening recession and the risks are firmly for a quite deep and protracted weakness in activity and employment. An accelerating downward spiral of depressed consumer and producer confidence leading to declining demand, delayed or skipped investment, rising unemployment and still lower demand requires an early and forceful policy response. The global character of the downturn and the credit crisis exacerbate these woes and emphasise the need for decisive action. Inflation is fast declining and will next month fall below 2%. By mid-2009 consumer prices could be falling. We agree with the ECB that such an outcome may not turn into a prolonged deflation. But it will raise such risks, particularly if the cost of consumer staples as well as asset prices remains under downward pressure. In the November ECB statement, it was stated that “upside risks to price stability at the policy-relevant horizon are alleviating”. We are eagerly looking whether the ECB would now indicate that upside inflation risks have disappeared. That might also be a sign that the ECB would take a more aggressive stance on rates going forward. Such a prospect requires a far more aggressive policy response than the ECB has countenanced to this point. At very least to make its policy more accommodative, the ECB need to cut rates at least as fast as inflation is imploding, otherwise real rates will rise. In our previous ECB flash that previewed the November ECB meeting we suggested that the ECB would become an aggressive rate setter, but also pointed out that the orientation of fiscal policy would decide how aggressive monetary policy would become. Merkel lukewarm about coordinated fiscal policy The EU Commission unveiled last week proposals for a fiscal stimulus package worth 1.5% of GDP, but it received only a lukewarm response from a number of countries, particularly the German government. Chancellor Merkel is afraid that once more countries look to Germany for pulling the economy out of the morass. However, it is felt as unfair by Merkel as Germany has made great efforts in recent years to restore its economic health by far-reaching labour market reforms, wage moderation, budgetary austerity. The country also avoided a housing bubble and doesn't feel much enthusiasm to put these achievements in danger. On top of that the German government doesn't feel that tax cuts will make consumers spend more. On Monday, Merkel toned down her opposition as she said that Germany would keep all options open to tackle the economic crisis, but the risks are that it will remain a case of too little too late, putting more pressures on monetary policy to take the lead in aggressively fighting the recession. We still feel more confident in our expectation for an official ECB rate of at most 1.5%, to be reached in early spring. German bonds have thrived well in the current climate, but recently the short end of the curve lagged the longer end. A more aggressive monetary policy might still push the 2-year yield below 2%, an attempt that failed previously. 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.