The Least The ECB Should Do

January 14, 2009

The ECB will announce a fourth consecutive monthly rate cut at 12:45 GMT tomorrow.  Market participants expect a reduction of 50 basis points but not more. Officials have been coy in their rhetoric, pointing out that 175 basis points of reduction in the last three months are already in the pipeline.  With the February meeting just three weeks away, some officials even hinted at a pause.  The record 75 basis point cut in December was not a unanimous decision but rather a consensus that emerged after debate.  A 50-basis point cut this month would leave the rate level at just 2.0%.

The above arguments are rationalizations, even if the consensus is likely to prove a correct in magnitude.  At 2.0%, the refinancing rate would exceed on-year CPI inflation of 1.6%.  If ever the central bank rate should be allowed to dip below inflation, that time would seem now.  2.0% would in fact only tie the lowest ECB refinancing rate maintained for seven months in 1999 in which EUR/USD averaged $1.0545, 20% weaker than now.  Considering the exchange rate levels then and now and the extreme reluctance of financial institutions to lend at present, a 2.0% central bank rate now would represent much tighter monetary conditions in 2009 than in 1999. In light of very negative economic growth, rapidly receding inflation, and falling money and credit growth, there is no way that a refinancing rate of 2.0% can be considered appropriate.

Other central banks have done more than the ECB.  Going into Thursday’s meeting, the ECB’s 175 basis points of rate relief during the past three months was slightly smaller than what the Fed has done, and the U.S. central bank rate was already at 2.0% when October began.  The Bank of England has cut rates by 350 basis points, twice as much as the ECB in the past three months.

Projections for 2009 growth and inflation released by the ECB in early December now look much too high, that is optimistic.  A range of zero to minus 1.0% was offered for real GDP, implausibly implying positive growth between the fourth quarter of 2008 and fourth quarter of 2009. Growth in Euroland probably will shrink by at least 1.5% this year.  Industrial production and retail sales plunged at annualized rates in October-November of around 15% and over 2% compared to their 3Q08 levels.  German industrial orders sank at more than a 40% annualized pace in the first two months of last quarter.  The jobless rate has risen in each of the last four reported months.  The composite PMI index was at 38.2 in December compared to 43.6 in October, with two-month declines of 7.2 points in manufacturing and 3.7 points in services.  The PMI levels are consistent historically with negative economic growth last quarter of 4% or more.  Sentiment indices also have dropped sharply. The overall 67.1 reading last month was 20.4 points less than in September.  Trade figures also depict a cataclysmic slide in Euroland’s economy.  German exports fell 10.6% between October and November.  EMU’s second largest economy, France, has likewise experienced an extraordinary drop-off in foreign demand and exports.

At its last meeting, ECB staff projected CPI inflation this year of between 1.1% and 1.7%.  1.6% as of December 2008 was already under that range ceiling and down from 4.0% in July.  No reason exists to suggest that this very steep deceleration will flatten.  Producer prices fell in each of the last four report months and at an annualized pace of 9.8%.  Oil prices are presently 18% below their level when the ECB met in December.  The price components of the monthly sentiment indices compiled by the EU Commission show a swing from +12 in September to -7 by December among businesses and from +17 to +7 among consumers.

Money and credit growth are also collapsing, albeit from high levels.  Euroland’s M3 grew 7.8% in the year to November, down from 8.7% in October.  Loans to the private sector experienced the greatest month-on-month drop in 17 years and slid to 7.1% in November from 7.8% in October and 8.5% in September.  Private credit rose 8.2% year-on-year, down from 8.7% in October and 10.1% in September.  Lending to corporations has slowed to a 2-1/2 year low.

European fiscal relief, expressed as a share of fully employed GDP, is much less than what the United States plans.  The myth that Euroland might decouple from a financial meltdown that began elsewhere has been exposed.  A completely honest ECB would assert that price risks have swung to the downside and declare further that vigilance against excessively low inflation or outright deflation must be just as vigilant as the prevention of above-target inflation.  A rate cut this week of 50 basis points to 2.0% is the smallest rate reduction that ECB officials ought to engineer.  It is likely to be what they in fact present.



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