ECB Punts But Further Easing Possible in March

February 5, 2009

As foreshadowed, today’s ECB announcement of no change in rates and the ensuing press conference added little to the market’s information about the central bank’s thinking.  The key refinancing rate remains at 2.0%, down from a peak of 4.25% after cuts of 50 bps each in October, November and January plus a record 75-bp reduction in December.  The 2.0% level is now twice as high as Britain’s 1.0% Bank Rate and almost two percentage points above the 0.125% Federal funds target midpoint and the BOJ overnight rate target of 0.1%.  ECB President Trichet would not rule out the possibility of a rate cut in March.  Neither did he rule such in, merely saying that considerably more information would be available next month including new staff forecasts and that a decision will be based on the facts as seen at that time.  It has only been a comparatively short three weeks since the ECB met in January.

In theory, ECB officials run policy using a two-pillar framework, cross-checking their analysis of growth and inflation with their analysis of money stock and credit trends.  In truth, a third pillar now seems to be calling the shots, which is the assessment of inflation expectations based on a variety of public and private analyst estimates of such.  The main assertion of the statement released today is that medium-term expected inflation remains consistent with the Bank’s target of below but close to 2%.  Hence, not cutting rates further now does not constitute falling behind the curve.  This is a questionable foundation upon which to rest the defense of much higher interest rate levels than found elsewhere.  The confidence with which people hold views about inflation in two years’ time, whether such be revealed in replies to survey questions or in actual market behavior, is probably not that well grounded.  Policymakers should treat information about expected inflation as less reliable than measurements of actual growth, unutilized capacity, and price and wage trends.

The statement from the ECB acknowledges an “extended period of significant economic downturn,” with growth risks ( such as a deeper-than-assumed recession, protectionism, and disorderly financial market adjustments) biased to the downside.  Trichet denied any meaningful significance to the omission of any explicit comment regarding the directionality of net price risks, only saying that both upside and downside risks are present.  But a message was nevertheless sent in his choice of the word “disinflation,” that is to say slowing but positive inflation, rather than deflation, which connotes a declining general trend in prices.  A further deceleration of monetary and credit growth is said to corroborate the view that medium-term inflation will be consistent with target.

The medium-term orientation that ECB officials constantly embrace sounds better in theory than how the practice really works.  Two years ago at the press conference in February 2007, Trichet warned of upside price risks from the lagged effect of higher commodity prices, labor market strains as 2000 peaks in capacity usage are approached, and accelerating money and credit growth.  As a result, he promised a strongly vigilant policy against higher inflation.  Yes, inflation did go higher, rising to 3.1% by end-2007 and cresting at 4.0% in July of last year.  But the relevant expected inflation rate when the ECB met in 2007 was the current 1.1%, which is eight-tenths lower than it was in February 2007 and only half as high as the target.  So we have an instance here of a strong downward trend in inflation now despite strongly accelerating money and credit growth two years ago.  It’s fine to base inflation on models of the future.  Reacting to the present means reacting too late, because monetary policy changes impact the economy with long and variable lags.  But knowing what we do now also indicates that waiting until October 2008 before cutting rates at all constitutes a policy framework that is too wedded to modeling the long-term future when the accuracy of such forecasts is inherently subject to error.  Sometimes, you have to look outside the window to know which way the wind is blowing.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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