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ECB: Starting To Get Real
The European Central Bank is starting to get real. With its first-ever 75bp rate cut today, the ECB de facto acknowledged the severity of the current recession, at least to a significant extent. Coming after two 50bp rate cuts in the last two months, the overall amount of ECB easing is now quite impressive.
Unfortunately, the recessionary forces are even more impressive. Judging by the latest readings for leading indicators, for instance the composite PMI published yesterday, the risk to our own forecast that GDP will decline by 1.5% on average next year is still very much to the downside.
Seen from this angle, the ECB has not yet taken the likely severity of the downturn fully into account. Yes, the ECB today slashed its staff projections for growth and inflation by record amounts, taking the 2009 call for GDP from 1.2% to -0.5% and for inflation from 2.6% to 1.4%, judging by the midpoints of the ranges provided (see Figure 1). However, these projections are still way above our own forecasts of a decline in GDP next year of 1.5% and an average inflation rate of a mere 0.9%.
In his comments, Trichet signalled a turn to outright pragmatism, suggesting that the ECB would be ready to ease further by as much as needed without hinting in any way that new cuts are indeed already in the pipeline, or that the next cut could come on January 8.
We look for incoming data to be once again weaker than the ECB expects. If so, the ECB will probably have to reduce rates in January again, likely by 50bp. We also maintain our view that ECB will hit a 1.5% trough in rates by March 2009.
There are two possible explanations for what we consider a still rosy ECB staff projection of a mere 0.5% decline in 2009 GDP. Either the ECB really believes that the downturn will be very shallow from now on. Or the ECB thinks that it should err on the side of optimism to not be accused of stoking panic with its projections. The second explanation is probably partly valid. This may also explain why Trichet seemed to shy away from the word "recession".
Taken at face value, the very low ECB projection of a mere 1.0% gain in GDP in 2010 seems to be almost incompatible with the ECB declaration of a rebound in growth in 2H 2009. The 2009 and 2010 GDP forecasts look a bit as an attempt to stay optimistic on 2009, and to make up for it by not predicting much of a recovery in the year thereafter in the published numbers. But even adjusting for this, the 2009 calls still look too high, in our view
In one respect, cutting rates further may not be easy for the ECB. In retrospect, the ECB seems to view the 2003 decision to slash rates to 2% amid an unfolding debate on deflation risks as a mistake. Although the ECB did not go to Fed-style rates of 1% at the time, its own low rates still fuelled the unsustainable property booms in Ireland, Greece and Spain, which have now turned into spectacular busts. To prevent a repeat, many council members may be uncomfortable about going much below 2.5%, let alone going below 2%.
However, there are two stark differences to 2003: First, the economy now is in a serious recession. Second, the financial turmoil impairs the transmission of the monetary mechanism through the banking system to the economy at large. Thus, any rate cut now needs to be bigger to actually get through to the real economy. These arguments, and the avalanche of negative data, will probably convince the ECB council to go all the way to 1.5% in the end.
The ECB's new pragmatism also came through in Trichet's answer to the question whether the ECB could engage in "quantitative easing" if need be, that is in simply flooding the banking system with liquidity once it has exhausted much or all of the scope for rate cuts. Trichet pointed out that, with its bold liquidity injections, the ECB has already tolerated a major expansion of its balance sheet. He added that, if decisions on new facilities are needed, the ECB will take new decisions. He even considers it possible that the ECB will buy assets outright.
To sum up, the ECB has come a long way today. Although they still seem to underestimate the extent of the recession and of the likely fall in headline inflation, the pragmatic tone is reassuring. It strengthens our hope that, if the data indeed turn south further, the ECB will ease its policy further in an undogmatic fashion to a trough of 1.5%. At the new level of 2.5%, the ECB is nowhere close to running out of ammunition. No need to see too many Spaghetti Westerns, to paraphrase comments from one council member about the risks of shooting too early. A refusal to shoot in earnest today would have put the cavalry at grave risk of being run over by the bad guys, to stay with the Bini Smaghi metaphor.
Today's 75bp moved matched our minority forecast. According to the Reuters consensus survey from 26 November, 16 out of 73 pundits predicted the 75bp rate cut for today, with the vast majority going for a 50bp ease.
Trichet tried to pre-empt the deflation debate which is likely to get more vocal early next year. At current oil prices, headline inflation will fall temporarily to 0% in mid-2009, in our view, and may briefly turn negative. Trichet emphasised that the inflation trough in mid-2009 would only be temporary and thus not relevant for monetary policy.
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