Rate cut is neither guaranteed nor ruled out

THERE were few surprises at the outcome of the ECB’s first governing council meeting of 2012.

The agency kept its official key refinancing rate unchanged at 1%. It had cuts rates by 0.25% at each of its two previous monthly policy meetings, fully reversing the two 0.25% rate hikes implemented in April and July of last year.

After these two rate cuts, no change was expected last week, as the ECB took time to assess their impact and the effect of the range of other measures it had adopted to counteract the weakening economy and malfunctioning markets.

The recent rate cuts were triggered by the sharp slowdown in economic activity over the course of 2011.

It now seems likely the economy contracted in the final quarter of last year. Unemployment has also been rising since mid-2011, with the jobless rate reaching 10.3% in recent months.

Inflation was stuck at 3% over the autumn, but eased to 2.8% in December. The expectation is that the sharp economic slowdown will exert further downward pressure on inflation, helped also by oil prices movements. This should see the HICP rate fall sharply over the course of 2012 to comfortably below 2%.

The ECB staff quarterly economic projections, published last month, contained further significant downward revisions to growth forecasts. GDP growth for 2012 is now seen at 0.3%, down from the forecasts of 1.3% and 1.9% made in September and June 2011 respectively. GDP growth for 2013 is forecast at 1.3%.

The weakening economy is one of a number of serious issues confronting the ECB. It was forced to inject massive amounts of liquidity into the money markets and provide medium-term funding for banks.

In December, it eased collateral requirements for repo operations and extended the maximum repo term to 3 years. It also cut the reserve ratio from 2% to 1%, freeing up more collateral.

Last Thursday, ECB president Mario Draghi indicated these measures were having an impact. He noted the non-standard measures were making a substantial contribution to improving the funding situation of banks, which face significant redemptions in early 2012.

The strong demand at last week’s Spanish and Italian debt auctions also suggest some of these funds found their way into the short end of government debt markets and exerted downward pressure on bond yields. While the ECB has been adamant it cannot act as a buyer of last resort of government debt, it would seem its moves to loosen up access to cheap funding has encouraged investors to buy sovereign paper, especially at the short end of the curve.

Meanwhile, Mr Draghi gave no indication about future moves on interest rates. The refinancing rate is now back at its historic low of 1% but the market is pricing in at least one further 0.25% cut by spring, which would take the refi down to 0.75%, and possibly another cut to 0.5% later in the year.

Last week’s decision to keep rates on hold was unanimous. Mr Draghi indicated in the current very uncertain environment, the ECB will look at all factors and monitor all developments when making its rate decisions. Thus, another rate cut is neither guaranteed nor ruled out, but further weak GDP data could well see the ECB reduce rates by another 0.25%.

The problems facing the eurozone seem set to continue over the first half of 2012 at least. The decision by S&P to downgrade the ratings of nine eurozone sovereigns will only worsen the situation.

The agency may claim its actions are in keeping with market pricing behaviour over recent months but, in the current difficult circumstances, the downgrades will make it harder to find sustainable solutions.

* John Beggs, chief economist, AIB.