ECB and BoE Stand Pat While Downside Risks Grow

After raising interest rates in July, the ECB left rates unchanged today as expected. With oil prices down 20% from the time of the Governing Council's (GC) July meeting, and GDP and other economic indicators coming in weaker than expected, Jean-Claude Trichet emphasized that all of the developments "confirmed their decision" to raise interest rates last month. Oil prices may have fallen, but they remain "high and volatile." It will take more than just one month of falling oil prices to convince the GC that a new trend has materialized and that the risks of second round effects are fading.

While today's statements should be classified as hawkish, there were several elements to suggest that the ECB would be comfortable considering a policy easing at a later date. First was Trichet's admission that the ECB is "entirely pragmatic" and "humble in the face of facts and figures." Trichet noted that the weakening growth was only "in part" expected, and that the downside risks identified in prior statements were materializing. The Governing Council continues to stress the path of the economy, though, and not the growth rates. Signs that the quarterly growth rate of the Eurozone will not bottom out in the second to third quarter will have a greater influence on monetary policy than the levels of those growth rates. Given that the Eurozone economy likely contracted in the second quarter, this sets the bar pretty low for Q3 and shifts more of the focus to Q4. Moreover, Trichet added that the adjustment costs associated with high energy and food prices lowers the capacity constraints of the economy to some extent. This means a slower pace of economic growth than in the past can drive inflation higher.

As for monetary developments, the GC finds that "bank credit to nonfinancial corporations remains very robust." In a sneak peak to the Q2 Eurozone lending survey to be released next week, Trichet also said he saw "a little bit less net tightening" and still "no signs of significant constraints on bank loan supply."

We feel it will be more important to watch lending growth rather than GDP growth to sense a shift in ECB policy. The 3-month annualized trend in lending to the private sector has just moved into territory consistent with ECB cuts and would need to show further softening to spur lower interest rates. We believe headline Eurozone inflation has peaked in July, and that the risks are balanced that it will near 2.5% by December and that the ECB will cut interest rates in March and May of 2009.

The Bank of England left interest rates unchanged today, as well. With no statement, the current thinking of the Monetary Policy Council will be clearer after the August 13th release of the quarterly Inflation Report and the August 20th release of the meeting minutes. What is clear is that the UK economy is quickly decelerating and has a real risk of slipping into a recession over the next few quarters. Last month's minutes revealed a tenuous decision to keep rates unchanged, with the bigger issue being that a hike would be unanticipated by the market, not that it was entirely unwarranted. If oil prices continue to moderate as we expect, though, we think the merits for a near-term rate cut are much stronger in the UK than in the Eurozone. While we continue to look for four cuts from the BoE in October, January, March, and May, there is a strong risk that the October cut may be too bold given the current economic uncertainty.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.