The decision by the European Central Bank to cut its main refinancing rate by 50 basis points to an historical low of 2% on January 15 came as no surprise to the foreign exchange market. Nor did the slight weakening of the euro as a result.
The general perception that the ECB remains stuck behind the curve made it almost inevitable that whatever central bank president Jean-Claude Trichet and his colleagues decided to do, it would result in some kind of sell-off in the euro. A failure to move would have been taken as a sign that the ECB was totally clueless, while a bigger cut would have been taken as a tacit admission that the central bank was, at best, misguided in its earlier assertions about the state of the eurozone’s economy.
Struggling to catch up
Holger Schmieding, Bank of America’s chief economist, Europe, was critical in a snapshot analysis he sent out to clients just after the cut was announced. Schmieding states that the ECB was “struggling to catch up with reality”, adding: “In the press conference, Trichet virtually ruled out a rate cut at the February meeting in three weeks’ time, referring to the ‘important rendezvous’ in March instead.”
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“We expect the data to once again be worse than the ECB is now factoring in, tilting the balance firmly towards a new cut in March” Holger Schmieding, Bank of America |
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Schmieding is something of an expert in interpreting the ECB’s rhetoric; he believes that the ECB council is split on whether or not to drop rates even further. “Our interpretation of the somewhat unwieldy ECB semantics is that the council may be split on the rate outlook,” he points out. “Some members may already be convinced that the ECB needs to slash rates to record lows in response to the worst recession in at least three decades. Other members probably maintain the view that, because the 2003 cut to 2% turned out to be a mistake later on, the ECB should now stand firm and not create the next bubble by an overly loose policy.” He adds: “The ECB has now apparently braced itself for a much deeper downturn than they expected in December. However, Trichet still insists on potentially impairing his credibility by refusing to use the word ‘recession’. At its December meeting, the ECB had projected a mere 0.5% decline in 2009 GDP, far more optimistic than our –1.5% call at the time. Since then, we had to downgrade our 2009 call to –2.6%. Despite Trichet’s downbeat assessment of the economy today, we don’t think that the ECB is quite there yet, especially as the key risks to our call still seem to be on the downside.”
Awareness deficit
Schmieding details some recent evidence that suggests that the ECB is not fully aware of what is going on in the real world. He writes: “Throughout November, the ECB had signalled that it does not want to cut rates by more than 50 basis points in December, only to live up to our call of a 75bp cut on December 4 in response to bad data. After the December cut, the ECB signalled that it probably would stay on hold in January, only to live up to the forecast of a 50 basis points cut today, again in response to unexpectedly bad data. Now, the ECB signals a wait and see attitude with a good chance of a further cut in March. We expect the data to once again be worse than the ECB is now factoring in, tilting the balance firmly towards a new cut in March.”
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“I would rather listen to
Richard Morrish, |
According to Schmieding, the talk from the ECB suggests that there is growing resistance to following the US Federal Reserve and possibly the Bank of England in slashing interest rates to virtually zero. Bank of America predicts that the eurozone’s refi rate will bottom out at 1.5%, although it admits that a further intensification of financial turmoil could force a reluctant ECB to cut to 1%. Richard Morrish, head of research at Swiss-based Mig Investments, agrees that the ECB is unlikely to cut much further but he is slightly less critical of the central bank’s performance than Schmieding. “The ECB is guided by the inflationary compass and as such has been slower than the rest to reduce rates. In fact, it is more a case that the ECB is determined to avoid being caught in a liquidity trap. This is a situation that has plagued the Bank of Japan since the 1989 stock market collapse,” he says.
Morrish adds: “Trichet is aware that a falling inflation number that is possibly going to turn negative does not mean to say that it will remain negative for the long term either. As he clearly indicated, inflation was rampant over the course of last year, only abating on the commodity bust in the third quarter. Thus it is very necessary to be cautious – having been bitten on the upswing part of the inflation equation that you don’t get caught.”
Not overcooked
Morrish argues that the ECB’s track record should give it greater credibility than either the Fed or the Bank of England. “It is important to remember that it was the ECB that did not overdo rates on the downside post 9/11, nor were they the fastest to raise them into the boom that occurred, and again they have been slow in reducing. So whilst everyone is critical of the current ECB policy decisions maybe if they look at the historical ones then they will see that they did not overcook policy in either direction whilst the US and the UK certainly did. I would rather listen to Trichet and his take on policy than listen to King or Bernanke.” Morrish’s research is invariably interesting, mainly because it is always so different from the mainstream.
