Further rate cut unlikely but never say never

THE ECB has implemented its seventh rate reduction in official interest rates in seven months in the euro area.

The post-meeting press conference made it clear that the decision was taken in the context of the severe downturn in economic activity which has hit the euro area and global economies.

Interestingly, ECB president Jean-Claude Trichet gave a strong hint that the forthcoming Q1 GDP report for the zone (due out on Friday) will be significantly weaker than previously expected, possibly even weaker than the roughly 2% plunge we have been pencilling in.

As a result, he indicated that next month’s ECB staff forecast update would show a significant downward revision. His comments point to an expectation for the economy to contract by around 4% this year on average, considerably weaker than the latest (April) consensus forecast of -3.3% and our own forecast of -3.7%.

In addition to the rate cut, the ECB also unveiled a number of other “non-standard” initiatives.

Beginning in June, its liquidity provision will be extended to a maturity of 12 months, as had been expected. And, in a surprising development, the ECB announced its intention to purchase euro area covered bonds (CBs).

CBs are debt securities backed by cash flows, often from underling loan assets such as mortgages. Trichet signalled the ECB’s intention to purchase €60 billion of such assets, though there were no details on exactly how the scheme will operate (such details will come in a month’s time).

In Trichet’s own words, these decisions were taken “to promote the ongoing decline in money market term rates, to encourage banks to maintain and expand their lending to clients, to help improve market liquidity in important segments of the debt securities market and to ease funding conditions for banks and enterprises”.

The announcement of a CB purchase programme has already fuelled debate among analysts as to whether or not this measure constitutes a move to full-on quantitative easing (QE), as has already been implemented in the US and Britain.

It is not entirely clear if this is the ECB’s intention. To answer that question definitively we will likely have to wait for the details on how exactly the purchases will be financed.

But Trichet explicitly played down the view that it was QE and said it is aimed more at trying to improve the functioning of an important area of the markets that had been badly hit by recent turbulence, (rather than at trying to directly boost money and credit, and hence nominal spending in the economy – the traditional objectives of QE).

In any case, overall, we welcome these latest developments from the ECB and regard them as helpful further steps in the context of what has been an extensive policy response by the ECB to the current crisis.

In terms of what happens from here, one point of interest was Trichet’s revelation that the governing council did not decide that rates were now at their lowest possible level, implying that rates could conceivably go below 1%.

However, he stressed that the level of rates was now appropriate. This latter point is important as it amounts to a steer that it would likely take significant downside surprises in incoming newsflow, over and above what is now already being factored in to its latest, much weaker forecasts, to prompt the ECB into further action on the rate front.

While further accelerated weakness is not impossible, recent trends in the economic numbers have been more encouraging, and are pointing to some stabilisation in activity of late. This suggests that the downward pressure on growth forecasts is set to diminish.

The news that the council appears open to the idea that rates could be reduced further is important. However, on balance, we retain our view that last week’s move will prove to be the last of the current cycle.

Simon Barry is senior economist with Ulster Bank Capital Markets