ECB Will Print More Money at Cheaper Prices, Cuts Rates

Thursday, November 06, 2008

Taking advantage of lower commodity and energy prices while facing economic headwinds from a contraction in retail sales the European Central Bank (ECB) lowered its key refinancing rate another 50 basis points to 3.25%, meeting market expectations. The deposit facility rate was brought down accordingly to 2.75% and the discount rate to 3.75%.
In the UK the Bank of England cut its key interest rate a massive 150 basis points to 3% despite headline inflation of 5.2%.
Alas, the moves did not help to calm capital markets. European stock exchanges barely came off their day's lows. Gold surged $20 to $760 while Federal Reserve Notes experienced a light boost after the ECB's announcement.
The ECB decision reflects a continuation of the strategy to provide banks with all the liquidity needed and will comfort European policymakers who are fearful of a recession in 2009. The easy credit may accelerate inflation again, though.
In his introductory statement ECB president Jean-Claude Trichet said first that inflation, now at 3.2%, is expected to continue on a slow downward path to the target rate of 2% in 2009.
The outlook for price stability has improved further. Inflation rates are expected to continue to decline in the coming months, reaching a level in line with price stability during the course of 2009. The intensification and broadening of the financial market turmoil is likely to dampen global and euro area demand for a rather protracted period of time. In such an environment, taking into account the strong fall in commodity prices over recent months, price, cost and wage pressures in the euro area should also moderate. At the same time, the underlying pace of monetary expansion has remained strong but has continued to show further signs of deceleration. All in all, the information available and our current analysis indicate a further alleviation of upside risks to price stability at the policy-relevant medium-term horizon, even though they have not disappeared completely.
He later retracted a bit, saying that a resurgence of commodity prices poses an upside risk to price expectations.
Looking forward, recent sharp falls in commodity prices, as well as the ongoing weakening in demand, suggest that the annual HICP inflation rate will continue to decline in the coming months and reach a level in line with price stability during the course of 2009. Depending, in particular, on the future path of oil and other commodity prices, some even stronger downside movements in HICP inflation cannot be excluded around the middle of next year, particularly due to base effects. These movements would be short-lived and therefore not relevant from a monetary policy perspective. Looking through such volatility, however, upside risks to price stability at the policy-relevant horizon are alleviating. The remaining upside risks relate to an unexpected increase in commodity prices, as well as in indirect taxes and administered prices, and the emergence of broad-based second-round effects in price and wage-setting behaviour, particularly in economies where nominal wages are indexed to consumer prices.
Robust growth in money supply, although decelerating, does not correlate to the economic slowdown, which could be longer than expected, said Trichet.
The intensification and broadening of the financial market turmoil is likely to dampen global and euro area demand for a rather protracted period of time.
Trichet mentioned however that outflows from money market funds wound up in overnight deposits due to sustaining strains in financial markets, creating shifts in the monetary base.
The annual growth rates of broad money and credit aggregates, while still remaining strong, continued to decline in September. Taking the appropriate medium-term perspective, monetary data up to September confirm that upside risks to price stability are diminishing but that they have not disappeared completely.
A closer examination of the money and credit data indicates that the recent intensification of financial tensions has already had an identifiable impact, particularly in the form of outflows from money market funds and greater inflows into overnight deposits. However, the full impact of investors’ uncertainty on their portfolio allocation behaviour is still to be seen in the coming months. Both portfolio shifts between non–monetary and monetary assets and shifts between different types of monetary assets can therefore not be ruled out in the period ahead. Hence, such effects will need to be taken into account when assessing monetary growth and its implications for price stability over the medium term.
In plain language, expect more "asset" classes, especially Eurozone government bonds, to deflate overnight in the future when a panicky investing crowd will stampede to the exit.
Widening yield spreads between German bunds and Italian and Spanish government bonds as well as Austria's retraction of a bond offering last week clearly signal that all is not well in the Eurozone financial markets. Read more about it at Ed Hugh's Eurowatch blog.

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