Tomorrow's ECB Rate Decision

November 5, 2008

Unlike the Bank of England, I do not expect ECB officials to cut rates by more than 50 basis points, but they probably should. At a prescheduled meeting on October 2nd, ECB key rates were left unchanged even thought a cut was discussed. The released statement after the October 2nd meeting observed that downside risks to growth had mounted, but asserted that upside price risks had only diminished, not disappeared. Labor productivity had dropped. Second-round inflation remained possible because of the persistent practice of wage indexation. Officials warned that commodity prices could turn higher again. The trend toward rising expected inflation had stabilized but not reversed fully. Trichet maintained his distinction between monetary policy and liquidity-enhancing operations. Six days later, the ECB joined the Fed and several other central banks in cutting interest rates, implementing a drop of 50 basis points to 3.75% in the refinancing rate, switching to fixed rate tenders at that level with banks determining the quantity sold and, one day later, cutting the marginal lending rate/deposit rate corridor surrounding the refinancing rate to 100 bps from 200 bps (those rates are now respectively 4.25% and 3.25%). All the central banks that cut rates in concert on October 8th released individual statements, and the ECB’s seemed more sanitized than most.

The green light for a rate cut was not the intensified financial crisis or resulting augmentation of downside growth risks per se, but rather a further diminishing of “upside risks to price stability.” With all that had happened, ECB officials were not prepared to say that risks to price stability were now biased to the downside, only that upside risks were shrinking. The statement made the point that ECB officials had conferred by teleconference, thus not in the formal face-to-face structured way that it breaks down monetary policy making at scheduled monthly rate-setting meetings. Speaking for the euro area only, comments were limited to explaining why inflationary risks had fallen and why it is “imperative” to avoid second-round effects and anchor inflation expectations. No explicit description was made about the outlook for growth in the euro area or financial turbulence in the region being altered from conditions when the Governing Council had met on October 2nd. And no hint was given that another rate cut would be necessary, likely or required as soon as its scheduled meeting on November 6th. The euro was 4.9% stronger against the dollar and 2.5% higher in trade-weighted terms on October 8th than now, and Euribor rates have declined as well since the concerted intervention. These developments and lower oil prices, which were about $94/barrel on October 8th, have continued to loosen monetary policy.

Economic data from Euroland have deteriorated sufficiently during the past month to warrant a rate cut of at least 50 basis points. The October composite PMI decreased 3.2 points to 45.3, lowest in 65 months. The service-sector PMI dropped 1.5 points to 48.3, while the factory index lost 3.9 points to 41.1. Some of the data were really dreadful like a reading of 29.5 for new business in Spain’s manufacturing survey. The composite score for Euroland input prices of 54.2 was well below September’s reading of 61.1. Overall economic sentiment fell to 80.4 in October from 87.5 in September, with a 5-point drop in consumer confidence and retail-sector sentiment, a 6-point decline in both service-sector and industrial-sector confidence, and a 4-point reduction in the construction component of the survey. Industrial output in Euroland posted a third consecutive quarterly decline, dropping 1.2% not annualized in 3Q, and German retail sales plunged 2.3% in real terms during September. The region’s labor market has held up better than Britain’s or America’s, but it is poised to perform much more poorly in coming months.

The clinching argument against a rate cut at the high end of expectations, that is above 50 basis points, is the continuing militancy of Germany’s pace-setting metal-workers’ union, which is threatening a general strike from November 17th. A 50-basis point reduction in the refinancing rate to 3.25% from 3.75% cuts the cost of finance by about 13%, not much less than a 75-bp cut in the British bank rate to 3.75% from 4.50%, which amounts to about a 16% drop. Many analysts will be disappointed by a rate cut that does not surpass 50 basis points. For the next 12-18 months, its hard not to conclude that price risks lie to a smaller actual level in 2008 than the 3.5% baseline forecast of the central bank. The forecast range for 2009 has a midpoint of 2.6%, which also looks too high. If officials are prepared to now say that inflation risks are skewed to the low side of their projections, a framework would be in place for the central bank to ease by more than 50 basis points. But remarks by officials have not implied that a more dramatic easing is expected than the consensus of private analysts. The ECB has never moved its refinancing rate, up or down, by an increment of greater than 50 basis points in its nearly ten years of existence.

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