The Right Mix of Data for a Big Rate Cut

Almost every day brings another raft of disappointing news on the Eurozone real economy. The European Commission survey points to a further deterioration in economic activity in late 2008, following the “technical recession” of 2Q/3Q.

Since inflation is also receding faster than anticipated, there is a clear case for a “higher-thanusual rate cut” on December 4 by the ECB. We expect a 75bp cut, while acknowledging a 40% risk of a more traditional 50bps relaxation, since the debate at the Governing  Council still seems to be open.


Deep Recession and Faster-than-Expected Deceleration in Inflation

The “technical recession” of 2Q/3Q 2008 was just an appetizer. GDP growth in the coming quarters is likely to dig much deeper into negative territory. The ugly recession of 1993 is now clearly the benchmark to assess the current woes of the Eurozone economy. The economic sentiment index published on November 27 by the European Commission stood in November 2008 at its lowest level since August 1993. Decisive economic policy action must be taken now.

Compared to 1993, monetary policy today is both less constrained and less powerful. The monetary union allows the central bank to concentrate on the state of the economy instead of pursuing exchange rate targets, but the seizure on the money market will impair the transmission of the monetary stimulus. The further deterioration in survey data, together with the sharper-thanexpected deceleration in German inflation, opens the door to a higher-than-usual rate cut in the coming week. Although it is too late to avoid a full-scale recession in the Eurozone, there is still time to stop a genuine credit crunch: bank lending data for October, also released on November 28, suggests that credit flows are being scaled back, but not (yet) in a spectacular fashion.

The EC survey for November reflects a widespread deterioration in economic sentiment across sectors. Confidence fell by 7 points mom in industry, 5 points in the services and 4 points in construction. Consumers only slightly revised further down their assessment of the economic situation (–1 point in one month), albeit to a very low absolute level (only 4 points above the historical low of July 1993). This may be explained by the ongoing correction in energy costs since the peak in July 2008. The consumers’ assessment of “price trends over the next 12 months” fell spectacularly from 19 in October to 11 in November, the lowest level since April 2005. However, Eurozone households are aware of the deterioration of the labour market. The “unemployment over next 12 months” component shot up to 44 in November from 34 in October, the highest level since 1994.

Eurozone employees are perfectly right to worry about their jobs. Hiring intentions in manufacturing declined significantly to –22 in November from –16 in October, hitting the lowest level since 1996. In services, hiring intentions touched in November their lowest level since the series started in 1997. Interestingly, hiring intentions fell markedly in Germany in November (–8 points mom in manufacturing, –6 points in services). This suggests that the impressive resilience of the German labour market is about to end. The 10k decline in unemployment numbers in Germany for November is likely to be a last gasp.

Inflationary pressures are correcting at a very fast pace in the Eurozone. Selling-price expectations in manufacturing fell further to +1 in November from +6 in October. They stood in November below the long-term average level for the first time since January 2006. The decline since a peak at +20 in July has been massive. This echoes the sharper-than-expected deceleration in German inflation in November to 1.5% yoy from 2.5% in October. The combination of a further deterioration in survey data and fast-falling inflation may have shifted the terms of the debate at the ECB Governing Council around the magnitude of the widely expected—and repeatedly preannounced— rate cut in the week ahead.

A number of Governing Council members, such as Bini-Smaghi, Mersch or Nowotny, are seemingly in favour of “measured rate cuts”, i.e. a “relaxation as usual”, with 50bps as the upper bound of possible moves. Their analysis is probably based on two elements. First, keeping some “ammunition” for the ECB through 2009 if the economic situation worsens further. Second, avoiding a risk of “over-stimulation”, if policy interest rates were to fall too far below the equilibrium rate. Arch-hawk Weber may have built a bridge between the “cautious relaxation camp” and those on the Governing Council who would be ready for bolder moves.

By saying recently that monetary moves should be symmetrical after bubbles to avoid laying groundwork for new excesses, he seemingly opened the door to a “higher than 50bps” cut, while starting to fight the “next battle” already, i.e. the moment when the ECB will have to start taking back its current relaxation. A consensus could emerge at the Governing Council on a 75bp cut “traded” against  an agreement that monetary stimulus would be removed quickly when the first signs of recovery start appearing. However, we think that the debate is not yet over at the Council, and still see a 40% probability that the ECB will only deliver 50bps in the coming week, while 75bps is our central scenario.

Even if the credit market turmoil is seriously impairing the transmission of any monetary relaxation, a recovery in bank lending could still occur. Actually, bank lending remains surprisingly resilient, at least for the corporate sector.

In October 2008, loans to the private sector decelerated to 7.8% yoy from 8.5% in September. However, the measure in “outstanding loans” in year-on-year terms, the preferred ECB presentation often blurs the picture because of large base effects. When looking at monthly credit flows, which we deseasonalise using the canonical X12 method, the levels remain relatively robust. Flows stood at €33bn in October for credit to the corporate sector, only slightly less than in  September (€35.8bn). True, the decline since the peak at €55.8bn in July 2007 has been steep, but monthly flows are still well above their 10 year average (€22.5bn per month).

The resilience in lending to the corporate sector contrasts sharply with the further decline in mortgage lending (€9.6 bn on average in the 3 month to October 2008), well below the 10-year average (€16.8bn per month). This contradicts the latest bank lending survey, which pointed at more tightening in credit standards for corporate loans than for mortgages. The existence of  pre-definite credit lines for the corporate sector may explain at least part of this contrast. Still, the credit market turmoil started more than a year ago. It is likely that some of the existing credit lines have been renegotiated and that banks, in aggregate, could impose a cut in the maximum amount businesses can draw. However, long-term relationships between banks and corporations may protect to some extent the credit lines.

The resilience in credit distribution to the business sector does not mean that the current recession is shallow. In times of economic downturn, the fall in loans financing investment can be partly offset by an increase in “bridge loans” or “survival lending”. However, the fact that credit is still flowing means that we are not (yet) in a genuine credit crunch. There is still time—but only a bit—to act.

source: Bank of America