ECB Cuts And Hints At Further Easing

Daily Forex Fundamentals | Written by KBC Bank | Jan 16 09 06:59 GMT |

... ECB cuts rates for the 4th month in a row. Mr. Trichet keeps hope alive for further chop in March. Tone of comments underlies concern about weakening economy. We still see rates reaching a floor of 1% by summer. It took 32 months for the European Central Bank to raise rates from 2 per cent to 4.25 per cent. It has taken just 4 months to reverse this process. The sharp divergence between the pace at which interest rates (and many other asset prices) rise and fall calls to mind the comparison between escalators on the way up and elevators on the way down. The key question now is whether rates have further to fall and when any drop might occur. Although Mr. Trichet was his usual guarded self at today's press conference, it was significant that he didn't seek to rule out the possibility of further rate cuts. Indeed, he emphasized that 2 per cent was not necessarily the lower limit for rates. He indicated that the March Governing Council meeting would be 'an important rendezvous'. This suggests the strong possibility of a further rate cut in March. We think an emerging picture of a further sharp deterioration in activity accompanied by strong disinflationary pressures will prompt a fall in ECB rates as low as 1% in the summer. Today's press conference statement by Mr. Trichet was less hawkish than might have been feared. This probably reflects three considerations. First of all, the scale of deterioration in Eurozone activity suggested by recent economic indicators may have come as a major surprise to the ECB and made the Governing Council less resistant to the possibility that rates may need to fall below 2 per cent. Second, there may be concern that any signal that rates were unlikely to fall further could cause major problems for financial markets that are very nervous and fragile at present. An adverse reaction could have triggered an unwelcome rebound in market interest rates, a sell-off in equity markets and a rise in the value of the Euro on FX markets. Clearly such developments would amount to a de facto tightening of policy which the ECB would be keen to avoid at this point. A third factor in both today's rate decision and the tone of Mr. Trichet's comments might well be recent evidence that the downturn in activity was being felt more acutely in Germany of late. Previously, influential ECB Governing Council members such as Mr. Weber, the head of the Bundesbank and Mr. Stark, a former German Finance Ministry and Bundesbank official, had tended to downplay the prospect of aggressive ECB policy actions. However, very recently, prospects for the German economy have taken a marked turn for the worse. Together with more broadly based signs of economic difficulties worldwide, this may have lessened the resistance of the hawkish wing of the ECB to a further easing. Certainly, Mr. Trichet's comment that today's decision was unanimous is notably different to the impression that there were significant internal divisions in relation to the December rate cut. It is significant, if scarcely surprising, that even after today's rate cut, the ECB continues to recognise that the risks to economic activity are on the downside. We think that the evidence of the next month or so will point towards a further intensification of those risks and prompt a further easing in policy at the March Governing Council meeting. Mr. Trichet made little effort to rein in market expectations of further near term rate cuts beyond indicating that today's move incorporates the anticipation of future economic weakness. He also hinted at a downside limit to rates by referring to a determination not to get caught in a liquidity trap - in other words, not to have rates so low that changes in policy have little or no impact on the economy. While the concept of the liquidity trap is widely known, there is widespread disagreement as to whether it operates in practice. Certainly, few would suggest that Euro area rates are anywhere close to such a boundary. Mr. Trichet was reluctant to be drawn out in any detail on this topic. We think this implies he was trying to emphasise that the ECB did not envisage following the US and cutting rates close to zero. This still leaves considerable leeway for further easing. As if to emphasise this, Mr. Trichet repeatedly indicated that while the new level of rates is historically low 'we did not say 2 per cent is the limit'. We think the ECB will be forced to cut rates a good deal further in the months ahead. The speed of decline both in economic activity and inflation across the Eurozone is creating substantial scope for a further easing of policy. With Euro area GDP likely to shrink by around 1.5% in 2009 and inflation set to tumble towards 1 per cent, mechanical Taylor-Rule based estimates would imply the ECB refinancing rate could fall to around 1.25%. Diagram 2 below provides some historic context of the scope for further rate cuts. Since 1999, the ECB refinancing rate has averaged about 3.1%. This is roughly one percentage point above the average annual growth rate over that period, although the diagram shows that monetary policy typically responded to downswings in activity with some lag. Clearly, precedent hints at the possibility of extremely low rates in the coming year. Another way of assessing the scope for easing is to look at the ways in which 'real' or inflationadjusted policy rates have moved through recent economic cycles. Diagram 3 shows that the ECB brought 'real' interest rates (interest rates less inflation) down to zero at the low point in the previous rate cycle. Again, this points to a policy rate approaching 1% later this year as inflation eases further. In summary, today's ECB decision to cut rates by 50 basis points reflects a rapid and appropriate response to emerging signs of a further step-down in Eurozone economic activity. As Diagrams 2 and 3 suggest, the history of 10 years of ECB policymaking implies a greater sensitivity to changes in economic activity than most ECB comments would suggest. Although Mr. Trichet said that today's decision to cut rates by 50 basis points anticipates further economic weakness, we think the next couple of months will bring evidence of a significant deterioration in activity and in economic prospects which will prompt a further drop in inflation. In turn, this suggests the likelihood of further rate cuts in March and 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.