Economic indicators pile pressure on ECB
Against this background, it is hard to believe that the ECB hiked rates as recently as July. There has been a sea-change in its thinking on monetary policy since then, brought about by an abatement in inflationary pressures as oil prices collapsed and the eurozone economy hit recession, as well as worries about the deepening financial crisis.
It is clear that the ECB was not forward looking enough in terms of its monetary policy decisions in the earlier part of the year.
The summer rate rise stunned markets, given the worsening economic backdrop. It contrasted with the policy easing of the US Fed and Bank of England in the first half of 2008.
The ECB, though, has been forced into a policy reversal and is now cutting interest rates rapidly to bring monetary policy more into line with economic realities.
The ECB did not attach much weight until recently to the turmoil in financial markets and its implication for the real economy. While it tried to distinguish between the operation of monetary policy for price stability purposes and money market operations, the lines became increasingly blurred.
The rise in interbank rates and seizure in credit and money markets resulted in a sharp tightening of financial conditions that was completely inappropriate in an already weakening economy, increasing risk of deep and prolonged recession.
Neither did the ECB pay enough attention to leading indicators showing a weakening in economic activity.
The latest readings from these indicators, in particular the PMI (purchase manager’s index) surveys and European Commission economic sentiment index, are truly awful. GDP contracted by 0.2% in the second quarter and a decline of around 0.2% may have occurred in the third quarter. Data will be published on Friday.
Leading indicators point to a marked fall in GDP in the fourth quarter.
The eurozone economy, then, has been in decline for most of this year and the recession is likely to last until the middle of next year, judging by the continued downtrend in indicators.
With interbank rates still very high relative to official interest rates, it is quite clear that rapid and significant policy easing is required.
Three month interbank rates are still about 4.4% after last week’s cut. Official rates need to be cut to very low levels to help bring down interbank rates, as has happened in the US.
The ECB did consider cutting rates by 0.75% on Thursday. It was a missed opportunity for a bigger cut, as the Bank of England slashed rates 1.5% that day.
However, inflation has started to ease, having picked up sharply earlier this year on the back of soaring food and energy prices. The consumer price index (CPI) hit a historic high of 4% in July but had fallen to 3.2% by October following declines in commodity prices, especially oil.
The recession and rising unemployment will put downward pressure on core inflation. The CPI rate should decline to 2% next spring and 1% by next summer if the fall in oil prices in recent months is sustained.
With inflation set to fall sharply next year, ECB president Mr Trichet hinted at his press conference that further policy easing is on the cards, and another 0.5% rate cut seems likely in December. In the last cycle, ECB rates were eventually cut to a low of 2%. On that occasion, the economy managed to avoid recession.
With the economy now in recession, inflation on the wane and interbank rates still elevated, ECB rates should be cut to at least 2% in the first half of 2009.
John Beggs, chief economist, AIB Global Treasury
