Tuesday, January 22, 2008
By JOELLEN PERRY (Wall Street Journal)
DAVOS, Switzerland -- As recession fears rout global markets, the Federal Reserve slashes interest rates and the governor of the Bank of England hints of another rate cut, what will it take for the European Central Bank to finally cut its short-term interest rates? The short answer now: A little time.
The ECB has been an outlier among major central banks since the summer, keeping its key rate on hold as inflation worries trumped growth concerns, even as the Fed, the Bank of England and the Bank of Canada cut borrowing costs to rescue ailing economies. "Now, the question for the ECB is not if they'll lower rates, but when," says Neville Hill, economist with Credit Suisse in London.
Pressure on the ECB is mounting. Investors Tuesday priced in up to three one-quarter-percentage point ECB rate cuts this year, which would bring the ECB's key rate to 3.25%. Markets are betting on a rate cut in May; some economists say signs of a weakening in euro zone growth prospects could bring a rate cut as early as March.
Despite some recent softening in their rhetoric, ECB policymakers have, so far, maintained that strong domestic momentum coupled with solid global growth could help the 15 nations that share the euro currency expand close to its 2% trend rate this year -- even as the U.S. slows. But "if the US problem is so large that the Fed has this kind of reaction, then it will have an impact in Europe as well," says Marco Annunziata, chief economist with UniCredit in London. "So the idea that Europe is doing just fine doesn't hold anymore."
But subtle shifts in ECB officials' recent rhetoric suggest the 21-member Governing Council may be starting to worry more about weaker growth than higher inflation. Several have suggested that new central-bank staff growth projections in March could come in under December's estimate of gross-domestic-product growth around 2% this year. Others have stressed that the current inflation increase will be short term and highlighted the rate should fall back below 2% in 2009. And tough ECB rhetoric about inflation preceded rate cuts back in 2001.
Moreover, lower rates in the U.S. -- and in the U.K. -- without a cut in European rates would put even more upwards pressure on the euro, which some analysts predict could hit $1.50 in the wake of the Fed's cut as investors flock to the promise of higher returns. That could crimp European export growth and suppress import prices, both of which could help push ECB policymakers towards lowering rates.
Bank of England Governor Mervyn King said in a speech Tuesday that U.K. economic growth could slow "quite sharply" near-term even though consumer-price inflation may accelerate. Speaking to businessmen in the west of England, Mr. King said that the central bank's key interest rate is probably restricting economic growth.
"In the short run, [tighter credit conditions] will slow economic activity, possibly quite sharply," Mr. King said, acknowledging that the central bank faces the difficult balancing act of supporting growth, while not allowing inflation to get out of control. "But we start the year from a position in which Bank Rate, at 5.5%, is probably bearing down on demand," he added.
The next meeting of the Bank's Monetary Policy Committee is now set for Feb. 6-7. Most economists expect it to reduce the key rate to 5.25% then; it cut the rate in December for the first time since August 2005.
Unlike the Fed, which is responsible for maximizing growth and minimizing inflation, the ECB's sole mandate is keeping euro zone prices steady. For policymakers to consider a cut, euro zone growth prospects need to deteriorate enough for policymakers to be able to argue that inflationary pressures are ebbing. There are signs of such deterioration already.
The ECB's most recent bank lending survey showed euro zone banks further tightened lending standards for households and firms late last year and expect to continue doing so. Policymakers and private economists alike already expect euro zone growth for the last three months of 2007 to come in well below the third quarter's 0.8% pace, perhaps as low as 0.3%. Fresh evidence of weakness could come this week, as both the euro zone purchasing managers' index -- which the ECB watches closely -- and a key survey of German business expectations are likely to continue slipping.
"Together with the ongoing weakness the US, that would be enough to make them change their rhetoric and make a U-turn on rates," says Mr. Annunziata. But he doesn't expect an ECB move until summer.
ECB policymakers have made clear why they haven't yet joined the Fed in cutting rates: Domestic inflation pressures remain strong. On the heels of two years of solid growth, unemployment hit a record low of 7.2% in November and factories continue working at near-capacity. In addition, soaring food and energy prices pushed euro zone inflation to a six and a half year high of 3.1% in November and December, well above the ECBs goal of just below 2%. Consumer inflation expectations are at multi year highs.
Paramount in the minds of policymakers is the danger that rising commodity prices will lead euro zone workers leverage to demand productivity-beating wage increases. ECB President Jean-Claude Trichet stressed after the ECB's most recent policy meeting on Jan 10 that the bank would act "pre-emptively" to forestall such spillovers. Days later, German train drivers won an 11% pay increase, in a deal that could herald similarly generous rises across the bloc.
As successful as the ECB was at keeping markets afloat with its liquidity injections last year, some economists say the continuing credit crunch offers a lesson on the primacy of the interest rate. "Ultimately, all the different vehicles the central banks have tried to provide liquidity to the system without changing the interest rate have proven only modestly helpful," says Kenneth Rogoff, a Harvard University economist. Since U.S. remains at the center of the subprime storm, "the ECB has the luxury of waiting longer. But eventually, they're going to have to turn course as well."