Trichet Propelled Toward Zero Rate by Deepening Slump

By Simon Kennedy

Jan. 12 (Bloomberg) -- The sliding European economy is propelling European Central Bank President Jean-Claude Trichet toward the zero-interest-rate world he sought to avoid.

A month after saying he didn’t want to be “trapped” with borrowing costs too low, Trichet may be caught with them too high, as the euro-region’s economy sinks faster than the ECB foresaw in December. As the bank’s governing council prepares to meet Jan. 15, caution from Trichet might prove costly, saddling Europe with a longer recession and weaker recovery than the U.S. faces.

“The economy is in a potentially dangerous situation,” says Gilles Moec, a London-based economist with Bank of America Corp. and former Bank of France official. “There is still a case for very aggressive action from the ECB.”

Accelerating job cuts and declining investment may shrink the economy of the 16 nations that share the euro by 2.5 percent this year, according to Bank of America and Deutsche Bank AG. That’s five times the rate of contraction the ECB staff projected last month.

The slide puts pressure on the ECB to follow the U.S. Federal Reserve, the Bank of Japan and the Bank of England by dropping its key interest rate to unprecedented levels. Trichet, 66, has resisted such a course, suggesting in a Dec. 15 meeting with journalists in Frankfurt that more cuts might not do much to free up credit, while fanning future inflation.

Euro Drops

Since then, data show Europe’s slump turning much worse. Services and manufacturing shrank last month by the most in at least a decade, and confidence among consumers is the weakest on record. Inflation fell below the ECB’s target of just under 2 percent for the first time since August 2007.

The euro today fell for a second day against the dollar and to a one-month low versus the yen as traders increased bets the ECB will cut rates.

The 22-member governing council meets in Frankfurt after having slashed its key rate by 1.75 percentage points since early October, to 2.5 percent. Economists expect a half percentage-point cut, to 2 percent, at this week’s meeting, according to the median estimate in a Bloomberg News survey. While that would match the lowest rate in the bank’s 10-year history -- reached in 2003 -- it would still leave the ECB with the highest benchmark rate among major central banks.

‘Sad Track Record’

“The ECB has a sad track record of always showing up late to the party,” says Carsten Brzeski, an economist at ING Group in Brussels.

Bank of America’s Moec predicts Trichet will take the rate down to 1.5 percent by the end of March. Thomas Mayer, chief European economist at Deutsche Bank in London, expects the bank to go as low as 0.75 percent by the middle of the year.

The European slide has steepened so rapidly that the ECB’s month-old forecasts of a 0.5 percent contraction this year and a 1.4 percent inflation rate already “look very unrealistic,” says Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc. He expects the economy to shrink 1.5 percent in 2009, helping pull inflation down to 0.7 percent.

More obstacles to recovery are forming. Europe’s exporters, already buffeted by fragile global demand, face fresh pain since the euro rose in December as much as 15 percent against the British pound and almost that much compared with the dollar, before surrendering some of those gains.

Faltering Demand

Lending to consumers and businesses failed to grow in November for the first time on record, according to a Dec. 30 ECB report. That’s a sign the ECB’s rate cuts so far haven’t revived credit, making it tougher for Europe’s corporations, which carry heavier debt loads than their U.S. rivals, to raise capital.

Scarce credit and faltering demand led Fiat SpA, Italy’s largest carmaker, to temporarily shut three of its biggest domestic plants this month after already idling 27 percent of its workforce in the fourth quarter.

Consumer confidence is likely to suffer even more as businesses cut payrolls. France’s Alcatel-Lucent SA, the largest supplier of fixed-line telephone networks, said Dec. 12 that it plans to eliminate 1,000 more managerial jobs.

As layoffs pick up, the unemployment rate will reach almost 10 percent in December from last month’s 7.8 percent, says Robert Barrie, chief European economist at Credit Suisse Group in London. That’s one reason “this year’s recession is likely to be the deepest and longest” Europe has endured in at least four decades, he says.

‘Behind the Curve’

Another curb on growth is that European governments are “behind the curve” in implementing stimulus packages and are “still underestimating the needs,” International Monetary Fund Managing Director Dominique Strauss-Kahn said in an interview. Deutsche Bank’s Mayer estimates that European plans will amount to about 1.5 percent of gross domestic product, less than half the 3.6 percent boost the U.S. will probably get.

The U.S. recession, which started in December 2007, is already the longest in a quarter century and may be followed by an anemic recovery heavily dependent on government spending.

Worldwide, the slowdown is damping inflationary pressures faster than economists had expected and bolstering the case for easier monetary policy. Oil prices are down 70 percent from their July peak of $147 a barrel, and Europe’s consumer-price inflation dropped more than forecast to 1.6 percent last month, the lowest level in more than two years. Commerzbank AG expects a negative rate of inflation by July, the first bout of declining prices in Europe since records began in 1991.

‘They Have to Cut’

The new environment led Stephane Deo, chief European economist at UBS AG in London, to revise his ECB expectations last week. After previously forecasting that policy makers would stand pat Jan. 15, Deo now sees a half-point reduction in the benchmark rate.

“They wanted to pause, but now they have to cut,” he says. “The economy is very, very weak.”

A reduction would be an about-face for Trichet. In the Dec. 15 meeting with journalists, he indicated that, after paring rates at the quickest pace in the ECB’s history, he wanted to wait for signs those steps were working rather than use up ammunition that might be more effective later. He also voiced concern that cheaper credit might sow the seeds of future inflation or pump up asset bubbles.

“Do we have a feeling there is a limit to the decrease in rates? At this stage, certainly, yes,” he said. “We have to beware being trapped at nominal rates that would be too low.”

ECB Reluctance

Julian Callow, chief European economist at Barclays Capital in London, says that view still prevails, and Trichet will either leave the benchmark rate unchanged or cut it by just a quarter percentage point this week.

“The ECB sees itself as an anchor of stability and is reluctant to lower rates too quickly,” he says.

Europe’s central bank was the only one to raise rates in 2008, so aggressive easing by other policy makers leaves it subject to accusations it is again out of step.

The Fed last month reduced its rate target to as low as zero, and the Bank of England last week pushed its benchmark down by a half point to 1.5 percent, the lowest level since the bank was founded in 1694.

Kenneth Wattret, senior economist at BNP Paribas SA in London, says failure to act this week may force the ECB to do more later to rescue an economy now “in meltdown.”

“The ECB has plenty of rate-cutting still to do,” he says. “If they opt for a ‘go slow,’ they will have to compensate for it with more aggressive action in the subsequent months.”

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