ECB Counters Faltering Economy With Record Rate Cut

Thursday, December 04, 2008

A multitude of recent bad economic data has lead to a record rate cut in the Eurozone. On Thursday the European Central Bank (ECB) cut its leading overnight interest rate 75 basis points to 2.50%, accelerating the downward spiral of interest rates after two 50 basis point cuts in October and November.
The strong move signals the willingness of the ECB to lend governments a helping hand in overcoming the current Eurozone recession that will become official in the next weeks. According to a first estimate by Eurostat the Eurozone economy continued on a downward path in Q3 2008, recording another quarterly contraction by 0.2% of Eurozone GDP.
It has to be seen yet that the aggressive loosening of monetary policy will bring another result than monetary inflation only. In the press conference following the rate setting meeting ECB president Jean-Claude Trichet warned not to mistake lower goods prices for a deflationary environment.
In his introductory statement, Trichet credited mainly sharply lower inflation - which has receded from a record 4% in July to 2.1%, remaining only a tick above the ECB's target rate of 2% or less - for the radical rate cut.
The significant decline in headline inflation since the summer mainly reflects the considerable easing in global commodity prices over the past few months, which more than offsets the impact of the sharp rise in unit labour costs in the first half of this year.
Looking forward, lower commodity prices and weakening demand lead us to conclude that inflationary pressures are diminishing further. The annual HICP inflation rate is expected to continue to decline in the coming months and to be in line with price stability over the policy-relevant horizon. Depending primarily on future developments in oil and other commodity prices, a faster decline in HICP inflation cannot be excluded around the middle of next year.
This outlook has also led to sharply lower inflation expectations, said Trichet.
Consistent with this assessment, the December 2008 Eurosystem staff projections foresee annual HICP inflation of between 3.2% and 3.4% for 2008 and declining to between 1.1% and 1.7% for 2009. For 2010, HICP inflation is projected to lie between 1.5% and 2.1%. The HICP inflation projections for 2008 and 2009 have been revised downwards substantially in relation to the September 2008 ECB staff projections, reflecting mainly the large declines in commodity prices and the impact of weakening demand on price developments.
In his monetary analysis Trichet pointed out that money supply growth, at 8.7% almost double the reference rate of 4.5%, continued to show signs of further depreciation, although at a high level. An intensification of the market turmoil since mid-September has not yet shown up in money supply due to shift in the M3 components itself, he said.
The most recent money and credit data indicate that this intensification has had a significant impact on the behaviour of market participants. Thus far, such developments have largely taken the form of substitution among components of the broad aggregate M3, rather than sharp changes in the evolution of M3 itself.
The latest available data, namely up to the end of October, reveal a continued moderation of the growth rate of loans to the non-financial private sector. At the same time, for the euro area as a whole, there were no significant indications of a drying up in the availability of loans. The annual growth rate of loans to households also moderated further, in line with the weakening of economic and housing market prospects and tighter financing conditions.
Summing it all up Trichet warned that risks to economic growth were sustaining. He saw the possibility that Eurozone growth could retract further while inflation shoukd remain below record levels due to diminishing demand.
In the view of the Governing Council, the economic outlook remains surrounded by an exceptionally high degree of uncertainty. Risks to economic growth lie on the downside. They relate mainly to the potential for a more significant impact on the real economy of the turmoil in financial markets, as well as concerns about protectionist pressures and possible disorderly developments owing to global imbalances...
To sum up, there is increased evidence that inflationary pressures are diminishing further and inflation rates are expected to be in line with price stability over the policy-relevant horizon, supporting the purchasing power of incomes and savings. The decline in inflation rates is due mainly to the fall in commodity prices and the significant slowdown in economic activity largely related to the global effects of the financial turmoil.

I would not buy Trichets complacency. The latest weekly financial statement of the ECB shows no structural improvement. Banks are still limping around with the help of more than one trillion Euros with bank credit. This monetary expansion will act as a strong counter force to efforts for lower inflation rates. Monetary inflation will begin to seep through into the real economy with a time lag of 6 to 15 months, menaing the Eurozone could be in for a bad price surprise next year.


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