ECB Preview

December 3, 2008

I expect the ECB to cut rates by at least 75 basis points despite a lack of verbal clues. Economic weakness has descended too quickly for shifting sentiment on the Governing Council of the European Central Bank to have been well-communicated in a fresh message. Even more importantly, inflation is receding faster than expected. A 50-basis point cut to 2.75% would leave the inflation-adjusted benchmark clearly in the black in circumstances that warrant a temporarily negative real rate. Consumer prices rose 2.1% over the past twelve months, half the 4% 12-month rise in July, and will climb by much less than 2% in the coming twelve months. PPI inflation has dropped by a third over the past three months to 6.3%. The PMI composite indices for both input and output prices were below “50” in November compared to respective scores of 68.3 and 55.8 in July. Labor costs are flattening, commodity prices keep sliding, and expected inflation has plunged among consumers and manufacturers since mid-summer. The composite PMI reading for overall activity was 38.9 in November, down from 48.2 three months earlier, and that for orders was at 36.3, down from 47.0 in August. Retail sales in October fell by 2.3% in Spain, 1.6% in Germany, 1.3% in Portugal and 0.8% in Euroland as a whole, which was twice as big a decline as expected. Private sector credit has decelerated sharply. Led by Germany, less new fiscal money will be offered in stimulus than one might hope. The various prior reservations of ECB officials to loosening policy more dramatically are weakening, and the central bank has fallen behind several other central banks in reacting to a dramatic swing in price risks away from inflation and toward deflation.

The table below compares the ECB refinancing rate level and its drop from peak with similar yardsticks for other central banks. Markets will be extremely disappointed if the ECB only cuts 50 basis points and the Bank of England and Reserve Bank of New Zealand on the same day ease by at least 100 basis points. A cut of only 75 bps would still signal a reluctance to proceed as boldly as many other central banks.

Level 3.25% 1.00 3.00 5.58 4.25 6.50 2.25
Drop -100bp -425 -275 -189 -300 -175 -225



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