European Interest Rates Still Moving Lower

The Bank of England (BoE) and European Central Bank (ECB) both delivered what the market and we were expecting today, with the BoE cutting rates by 50 basis points to 1.00%, while the ECB left rates unchanged at 2.00%. For both central banks, the economic assessment remains fairly gloomy, with the sharp contractions in the fourth quarter of 2008 expected to continue in the early part of 2009. Where they differ is on their expectations for inflation. The BoE continued to see a "substantial risk of undershooting the 2% CPI inflation target," while the ECB continues to expect "inflation rates in the euro area to be in line with price stability over the policy-relevant medium-term horizon." We expect both central banks to deliver interest rate cuts in March, with the risks tilted toward a 25 basis point cut by the BoE and a 50 basis point cut from the ECB, but as we discuss below, a smaller cut from the ECB cannot be ruled out.

While much of the prepared statement from the ECB's Trichet was unchanged from February, there were a few significant deviations. Last month, the Governing Council felt they needed further data and analysis to confirm the "severity and scope of credit constraints." This month, they confirmed a "significant weakening of corporate credit," suggesting a renewed concern regarding the impact of credit on domestic demand and inflation. Moreover, while the ECB maintains a baseline assumption that inflation will be in line with price stability, they removed their assessment that the risks around that forecast are balanced. With Trichet highlighting that 2.00% is not a bottom and even suggesting the market may be right to expect a 50 basis point cut in March, the bias here seems to be for an interest rate cut. However, the fact that Governing Council could not come to a consensus regarding the balance of risks does raise the risk about how big that cut may be. We currently place higher odds on the ECB delivering a 50bps cut in March - based on comments to that effect from Trichet during the Q&A portion of his press conference - followed by a pause in April. However, if business activity indicators and commodity prices show ongoing stabilization or if Trichet moves to backtrack from his comments regarding a possible 50bps cut in March, the ECB moving in monthly quarter-point increments cannot be ruled out. As we have been warning for some time, the ECB has a history of moving slower than other central banks and that inclination appears to be driving an internal debate within the Governing Council.

The BoE, on the other hand, appears to have no qualms about continuing to bring rates down toward zero. The rate of year-over-year inflation fell by a full percentage point over the previous month to sit at 3.1% in December. There was no mention in the statement this month of inflation expectations falling, which will reassure MPC members that these expectations are remaining somewhat anchored. The MPC still saw a "substantial risk" of undershooting the inflation target, in spite of the "significant impact" of past cuts as they feed through the economy. The statement clearly did not signal that the BoE is done cutting interest rates, but there was little to go on in assessing the size of the next cut. We continue to expect the BoE will slow the pace of easing in March and deliver a 25bps cut - but will eventually take rates near or at zero. These expectations will be fleshed out further next Wednesday (February 11th) when the BoE releases their new inflation forecasts in the quarterly Inflation Report, and the following Wednesday (February 18th) with the publications of the minutes from this meeting.

TD Bank Financial Group

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