03 December 2008

EZA 872 Report: ECB Observer

ECB 4 December Council Preview

CONTINUING RECESSION AND SHARP SLOWING OF 'HEADLINE' INFLATION POINT TO PROBABILITY OF 50-75 bp ECB RATE CUT THURSDAY, WITH ODDS ON 75 bp CUT

· Eurozone records technical recession in 2008 Q3, now seen likely to have deepened in Q4.

· 'Headline' inflation rate drops close to ECB's comfort zone and likely to fall further, with some (still slight) risk of moving into deflation territory in first half of 2009.

· External cost pressures continue to subside, despite euro weakness, and labour markets now easing, although unit labour costs and recent wage settlements still troublesome.

· Money and credit growth continue to slow but underlying expansion still strong and increase in liquidity overhang continues.

· Increased downside risks to economic activity and prices, coupled with continuing financial market tensions, points to a further cut in ECB rates, with 75 more likely than 50 bp.

In EZA's view a return to positive real growth is unlikely until well into the second half of 2009. This prospect, together with fast declining cost pressures and inflation expectations, can be expected to be reflected in large downward revisions of the Eurosystem Staff's December macroeconomic projections. EZA therefore expects the Governing Council to agree on a further significant reduction in interest rates this month. At last month's press conference, President Trichet steadfastly refused to rule this in or out.

In our view, the debate in the Governing Council this month will centre on the required scale and degree of monetary easing required to calm financial markets further and to counter the danger of a deep and prolonged recession, entailing serious deflationary risks, without stoking up fresh inflation risks over the medium term. Given the further deterioration in growth prospects and the decline in the inflation outlook over the past month, EZA believes that those Governing Council members who had been advocating a 75 bp cut in rates a month ago, rather than the 50 bp reduction delivered, will be pushing this time for at least a further 75 bp and possibly a 100 bp cut this month, whereas those who had argued for a more cautious approach to monetary easing will be looking for at most a 50 bp cut.

Given the need to reach a consensus, if not go to a vote, among the 25 members of the governing Council, it seems to EZA that the most likely outcome will be a 75 bp reduction, bringing the minimum bid 'refi' rate down to the relatively 'round' figure of 2.5%, a still slightly positive rate in ex post real terms, which also keeps some ammunition dry for a possible reduction to 2% or even below in the first half of 2009.

Although the signals remain heavily shrouded by the continuing imperfect functioning of the credit markets, financial market operators appear to be taking a rather more conservative view, with implied interest rates in the Euribor futures market apparently indicating a 25 basis point cut in three-month money market rates by the end of this year, with a further 25 bp due in the first half of 2009

© EZA