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ECB: Time For A Big Cut As Unemployment Soars And Inflation Plunges (powered by Bank of America) |
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28.11.08 12:58 |
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ECB: Time For A Big Cut As Unemployment Soars And Inflation Plunges
Can the ECB really afford to stay in the slow lane? While leading economic indicators are plunging at a record pace, inflation is tumbling and unemployment is soaring in the Eurozone. The case for a rate cut of more than the customary 50bp has never been stronger. In fact, we find it difficult to see any convincing argument against cutting rates by at least 75bp next Thursday.
Lower oil prices pushed Eurozone headline inflation down from 3.2% in October to 2.1% yoy in November, the lowest level since September 2007. The flash estimate for inflation confirms once again that the Eurozone never had a serious inflation problem beyond the one caused by the spike in prices for oil and food imports. Oil prices had added more than 1.5% points to headline inflation this summer. Jointly with higher food prices, this had sent headline inflation to a peak of 4%. If oil prices stay at current levels, headline inflation looks set to fall further to 2.0% in December or January and to fall below 2% thereafter.
In mid-2009, the energy component will probably subtract close to 2% from headline inflation. The recession is likely to dampen domestically generated inflation even further. But even if core inflation stays close to the recent level of 1.9% despite the recession, the base effect from the oil price spike until July 2008 will likely bring headline inflation down to roughly 0% in mid-2009, followed by some uptick in inflation thereafter, reflecting the base effects from the recent collapse in oil prices. Based on today's data, average inflation next year could well come in below our current 1.2% forecast.
Although the inflation data are likely to make the headlines today, the labour market data are the real shocker. According to Eurostat, the number of unemployed in the Eurozone surged by 225k in October, the worst monthly rise since the 1993 recession. Since hitting a trough in March, Eurozone unemployment has now risen by 884k in just seven months. Note that, according to separate German data, German unemployment still declined by 175k during this period. Unfortunately, the German labour market looks set to turn down sharply as well next year, with a rise in unemployment by at least 500k, in our view. As there is no sign that the wave of dismissals could abate elsewhere in the Eurozone, Eurozone unemployment could possibly surge by more than 2 million over the course of next year. Although wages in the Eurozone react less flexibly to shifting labour market conditions than they do elsewhere, the risk that wage inflation could rise beyond levels compatible with price stability is probably negligible for the foreseeable future, to put it mildly.
At its December 4 meeting, the ECB will have to slash its projections for growth and inflation by record amounts. In September, the ECB still projected for 2009 a gain in GDP of 1.2% and an inflation rate of 2.6% according to the midpoints of the ranges provided. We currently forecast -1.3% for GDP and 1.2% for inflation next year, with a serious downside risk to both calls. We do not expect the ECB to go down all the way to our forecasts in its new staff projections yet. But even if the ECB still sees a less severe recession and a less pronounced plunge in inflation, the new set of projections can hardly be compatible with interest rates above 2%. As a raging financial storm impairs the transmission of any monetary stimulus, rates needed to be cut more aggressively than usual to have an appreciable impact on the real economy.
Recent public speeches suggest that many ECB council members do not yet agree with this view and prefer to maintain a slower pace of rate cuts and "preserve some firepower" for later. But with ECB rates currently at 3.25%, and the 3-month Euribor at 3.85%, the ECB still would have ample firepower left even if they slash rates by 75bp or more next week. We see a 65% probability that the ECB will wake up to the scale of the current recession and deliver a 75bp instead of a 50bp rate cut next Thursday. If not, the deepening recession would probably force the ECB to make up for it by more aggressive easing in January.
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