05 November 2008

EZA 868 Report: ECB Observer

ECB 6 November Council Preview

50 BP RATE CUT HIGHLY LIKELY THURSDAY. (POSSIBLY 50 BP MORE DEC/JAN, BUT INFLATION GENIE STILL NOT BACK IN THE BOTTLE).

1. EZA sees another significant cut in the ECB's key interest rates, probably of 50 basis points (or even 75) bringing the ECB's minimum bid rate down from 3.75% to 3.25%, as highly likely and this is also widely expected among market analysts and financial market participants.

 2. The likelihood of such a cut, following hard on the heels of the internationally co-ordinated 8 October cut from 4.25% to 3.75%, was quite clearly signalled by ECB President Trichet in a speech in Madrid on 27 October, in which he said:

 "Taking into account the recent substantial decline in commodity prices, together with the substantial weakening in demand which has emerged lately, upside risks to price stability have diminished .... and .... also the fact that inflation expectations have significantly diminished, the Governing Council decided to diminish rates by 50 basis points on 8th of October. Assuming that the new information .... since then .... is likely to indicate a further alleviation of the upside risks to price stability in the medium term and a confirmation of the more solid anchoring of inflation expectations in line with our definition of price stability, I consider possible that the Governing Council would decrease interest rates once again at its next meeting on the 6th of November. It is not a certainty. It is a possibility [EZA italics].

3. This sstatement remains consistent with the continuing stream of fresh economic data, which points to a significant diminution in the upside risks, and some increase in the downside risks, to price stability. The ''headline' inflation rate fell further in October, according to Eurostat's latest 'flash' estimate, from 3.6% to 3.2% and measures of 'core' inflation steadied (see Chart 1, in attachment), and industrial producer prices actually fell for the second month in a row. Furthermore, inflation expectations, as measured by break-even rates in euro area government bond markets continued to tumble in October from the peaks seen in mid-summer, to levels markedly below the ECB's declared price-stability safety zone, although a previously comparable reduction in consumers' price expectations suffered a slight reversal (Chart 2).

4. There are also strong signs that the euro area could be lurching into a significant recession, with serious deflationary consequences. Following Q 2's 0.2% drop in real GDP, monthly indicators point to economic activity being no better than flat in Q3 (Chart 3), while industry and consumer confidence surveys suggest a sharp downward dip so far in Q4 (Chart 4).

5. Meanwhile, euro area money market conditions appear to have returned to some semblance of normality, helped by the internationally concerted 50 bp cut in official rates on 8 October and additional liquidity injections by the ECB, but they are far from out of the woods yet, with 3-month and 6-month money still around 100 bp above the ECB's key minimum bid rate (Chart 5).

 6. The annual growth rate of broad money (M3) and of credit extended to the private sector continues to subside, although both remain quite vigorous by historical standards at around 8.5% (Chart 6) and, with recent monthly monetary growth rates still quite lively (and recent month-on-month rises in the consumer price index very subdued), the liquidity overhang has continued to widen in nominal (and in real) terms (Chart 7).

 7. As long as some upside risks to price stability remain (from some continuing price-chain feed-through effects, excessive wage demands continuing sub-optimal (in ECB eyes) money and credit growth, EZA believes the ECB is likely to hold back any further reduction in its 'refi' rate below 3.25% until, early in 2008, it has a better handle on where the balance of risks between residual inflation and prospective recession/deflation is headed. It might then concede that a further 50 bp cut, to 2.75%, was necessary. We bear in mind that 15 national central banks and 6 ECB Executive Board members have to agree the outcome, by unanimity, consensus or (probably never, so far) by majority vote.

8. Taking this view, we might appear to be somewhat out of kilter with sentiment in the short-term interest rate futures markets, where there would appear to be a mounting consensus that the ECB's 'refi' rate might be cut to 2 3/4% by December and even close to 2.0% by the middle of 2009 (Chart 8).

© EZA