ECB Rates Set To Fall Sharply But Thursday Could Disappoint

• Awful economic outlook suggests ECB rates could fall to 1% by summer
• Eurozone economy could shrink by 1.5% implying severe downward pressure on inflation
• But ECB has many reasons not to cut aggressively on Thursday
• Some risk of 25bp cut or even no change in rates this week

A notably gloomier outlook for activity coupled with signs of a sharp easing in price pressures mean Euro zone interest rates have substantially further to fall in 2009. We now think the ECB will be forced to cut its key policy rate as low as 1% before the end of the summer as the economic newsflow in the interim is likely to highlight continuing downside risks to output and inflation right across the single currency area.

At the start of the new year it is worth emphasising how dramatic the transformation in the economic and financial landscape has been in the past twelve months. A year ago official interest rates in the US were still at 4.25% and markets were only pricing in cuts amounting to one per cent through 2008. However, the Fed funds rate is now effectively at zero and the Federal Reserve signalled in December that 'weak economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for some time'.

Even though European Central Bank officials have repeatedly emphasised differences in circumstances and economic structures on either side of the Atlantic, the economic evidence of the past year suggests some significant and painful similarities. Indeed, the US economy seems to have grown at a stronger pace in 2008 than the Euro zone and the drop in activity in the two areas is likely to be sharp and fairly similar in 2009. Diagram 1 illustrates how similar the recent trend in manufacturing conditions has been in the two economic zones. As the diagram shows, a precipitous decline in activity began on both sides of the Atlantic in early summer at a time when the Federal Reserve was cutting rates to 2 per cent and the ECB was raising rates to 4.25%. While the US may have suffered a greater direct hit from the current financial crisis, the global economic spill-over may have a more significant adverse impact on the Euro zone because of the greater importance of external demand to growth in the single currency area in recent years. In addition, the US macroeconomic policy response has been altogether faster and more forceful than in Europe.

Horrible economy, unhappy new year

Our judgement that rates need to fall sharply in the Euro area this year stems from increasing signs of a much more severe downturn than seemed likely a few short months ago. Recent economic data show a dramatic acceleration in the pace of deterioration in the Euro area economy in recent months. As Diagram 2 indicates the near vertical downwards momentum in survey data point towards a quarterly fall in GDP of between 0.8% and 1.0% in the final three months of 2008. More ominously, these surveys point towards the strong likelihood of a drop in Euro zone GDP of around 1.5% for 2009 as a whole. Such an outturn would be some significant distance below even the lower boundary of the zero to -1% range of GDP projections prepared by ECB staff ahead of the December Governing Council meeting. This shortfall gives some sense of the scale of the worsening of the economic situation in the past month or so. Moreover, as recently as September, the ECB were envisaging positive growth in the region of 1.2% in 2009. The speed and extent to which forecasts are becoming outdated is not a problem unique to the European Central Bank at present. Unlike many others, however, it has significant scope to implement an appropriate policy response to rapidly deteriorating circumstances.

Of itself, weaker economic growth wouldn't necessarily prompt a dramatic change in ECB policy, the ECB has regularly emphasised that price stability is the 'single needle' in its policy compass but a radically poorer economic outlook has major implications for inflation. Clearly a collapse in economic activity worldwide will bear down on prices. So too will the associated easing in commodity costs. Indeed, oil prices are now around 25% lower than they were at the time of the ECB's December projections. Finally, the exchange rate of the Euro is currently almost 5% higher than was assumed in the December projections. Drawing together the influence of an unravelling economy and these other factors that should act to depress inflation, a strong case can be made for substantially lower Euro area interest rates. This is the rationale for our expectation that policy rates could fall as low as 1% before the end of summer.

Rates will fall far. Will they fall fast?

Although we think the ECB will be forced to cut rates further than is generally envisaged we are not quite as sure that rates will fall as fast as some might expect. Indeed, we would not be surprised if the ECB disappointed confident market expectations of at least a 50 basis point rate cut this week. Several arguments suggest to us at least a risk that the ECB will not deliver an aggressive rate cut this Thursday. First of all, it could be the case that the ECB has not fully incorporated recent data into a clearly changed view of the economic outlook. Many indicators can be volatile around end-year and some on the Governing Council may want to see confirmation of a further step-down in activity before cutting rates for the fourth month in a row. It is also clearly the case that the substantial rate cuts implemented in October, November and December have not had any time to feed through to the economy.

Allied to this consideration is the recent behaviour of the money market. Mr. Trichet has emphasised that a key task must be to ensure that lower policy rates feed through the system. As Diagram 3 shows, a significant fall in the spread between interbank rates and market expectations of ECB rates points to some improvement in the workings of the money market significant of late even if this spread remains well above 'normal' levels. While there has been a tentative improvement in money market conditions of late, reports of very limited interbank activity and the record level of deposits placed at the European Central Bank by financial institutions (Diagram 4 overleaf) testify to the persistence of major problems in preventing a return to normal counterparty transactions. In this context some at the ECB might argue that the decision to widen the gap between the marginal lending facility and the deposit facility that was announced on December 18th last but only comes into effect on January 21st may effectively represent a further easing in policy in that it might discourage funds being placed with the ECB and force more counterparty trades.

One line of reasoning that follows from the technical problems suggests more time and effort should be devoted to improving the functioning of money markets to ensure the full pass through of previous rate cuts. On this view, further rapid and substantial rate cuts may be difficult for markets that are not working properly to 'digest'. So, it might be appropriate to give the money market more time to adjust to previous ECB initiatives before making another move.

Internal differences at ECB are important

Important as economic and technical considerations might be, there are two other very significant factors that may determine the outcome of this Thursday's Governing Council meeting. First of all, it seems fairly clear that some council members were uncomfortable with the 75 basis points reduction announced at the beginning of December. It may be that a compromise was reached that entailed an understanding that there would be no further rate cuts for at least a couple of months. While the intervening economic evidence makes a strong case for an early policy response, the medium term orientation of the ECB might suggest that a delay of a month or two, particularly at a time when significant fiscal packages are being finalised in the US and Germany, could allow for more informed action. Those more resistant to an early move might also fear that a further batch of bad news in the next couple of weeks would create pressure for another rate cut as soon as the next Governing Council meeting on the 5th of February. If the ECB were to respond mechanically to bad economic news, rates would probably fall every month in 2009 until they hit zero.

Will the ECB follow the markets lead?

Finally, the swing factor in next Thursday's decision could be the sometimes uncomfortable relationship between the ECB and financial markets. In contrast to the approach it adopted for the past few months, the ECB has been very careful not to give a clear signal as to its intentions on Thursday. Traditionally, this would have implied no policy change but in the current climate it could also be interpreted as signalling a tacit agreement with the consensus view in markets that rates will be cut by 50 basis points. While the ECB will be aware of the risks of a 'surprise' decision triggering increased market nervousness, there has always been a strong sense in Frankfurt that markets should not dictate policy. This may lead to an unwillingness to bow to market demands for a substantial rate cut on Thursday or it could mean that Mr. Trichet may strike an unexpectedly hawkish line at the subsequent press conference. Because it is frequently better to travel hopefully than to arrive, we think the possibility of a disappointing rate announcement softened by the promise of a policy future easing may be a significant risk on Thursday.

Before concluding, we must emphasise that we are raising the possibility of market disappointment at the ECB's tactics on Thursday. This doesn't detract from the more substantive judgement that rates will fall substantially in the months ahead. We think that the incoming news flow will force the ECB's hand and rates will fall to 1%. However, in stark contrast to developments in the US and UK, we continue to think that the path to substantially lower Euro area rates may be less straightforward than markets now expect.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.