ECB Watch: Benchmark rate expected to fall to at least 2% by mid-2009

By Finfacts Team
Nov 7, 2008 - 7:56:12 AM

ECB Watch: Following the decision of the European Central Bank to cut its benchmark rate to 3.25% on Thursday, the rate is expected to fall to at least 2% by mid-2009.

If the rate falls to 2%, borrowers on trackers, will in particular gain.

As banks charge their customers about 1.25% above the ECB rate, depending on the type of mortgage.

Borrowers could gain a €400 reduction in monthly payments from the cuts that began in October.

A homeowner on a €300,000 tracker mortgage will benefit from a monthly repayment fall by €90 from Thursday's cut, in addition to the October cut, which also reduced the repayments by another €90.

The IMF expects the advanced economies to have their first full-year contraction in 2009 since 1945.

The reduction in mortgage costs should give the Government some courage to tackle the issue of public sector pay as private sector workers will in general get no rises and be at risk of unemployment.

The following is analyses on the rate outlook from 3 bank economists.

AIB economists led by Chief Economist John Beggs:

The ECB finally sees the light:

The European Central Bank cut rates by 0.5% today, bringing the total reduction in official rates in the eurozone to 1% in the past month.

It is hard to believe that the ECB hiked rates as recently as July. There has been a sea-change in its thinking on monetary policy since then, brought about by an abatement in inflationary pressures as oil prices collapsed and the eurozone economy hit recession, as well as worries about the deepening financial crisis.

It is clear that the ECB was not forward looking enough in terms of its monetary policy decisions in the earlier part of the year.

The summer rate hike stunned markets, given the worsening economic backdrop and fragility of the financial system. It contrasted with the policy easing of the Fed and BoE in H1 2008. The ECB, though, has been forced into a policy reversal and is now cutting interest rates rapidly to bring monetary policy more into line with economic realities.

The ECB did not attach much weight until recently to the turmoil in financial markets and its implication for the real economy.

While the ECB tried to distinguish between the operation of monetary policy for price stability purposes and money market operations, the lines became increasingly blurred. The rise in interbank rates and seizure in credit and money markets resulted in a sharp tightening of financial conditions that was completely inappropriate in an already weakening economy, increasing the risk of a deep and prolonged recession.

Neither did the ECB pay enough attention to leading indicators showing a sharp weakening in economic activity.

The latest readings from these indicators, in particular the PMI surveys and EC’s economic sentiment index, are truly awful. GDP contracted by 0.2% in Q2 and a decline of around 0.1% may have occurred in Q3. Leading indicators point to a marked fall in GDP in Q4. The eurozone economy, then, has been in decline for most of this year and the recession is likely to last until the middle of next year, judging by the continued downtrend in leading indicators.

With interbank rates still very high relative to official interest rates, it is quite clear that rapid and significant policy easing is required.

Three month interbank rates are still around 4.5% after today’s cut. Official rates need to be cut to very low levels to help bring down interbank rates, as has happened in the US. The ECB did consider cutting rates by 0.75% today. It was a missed opportunity for a bigger ECB rate cut as the BoE slashed rates by a whopping 1.5% today.

With inflation set to fall well below 2% next year, ECB President Mr Trichet hinted at his press conference today that further policy easing is on the cards, and another 0.5% rate cut seems likely in December.In the last cycle, ECB rates were eventually cut to a low of 2%. On that occasion, the economy managed to avoid recession. With the economy now in recession, inflation on the wane and interbank rates still elevated, ECB rates hould be cut to at least 2% in 2009.

Eurozone Economy In Recession

Eurozone GDP contracted by 0.2% in Q2 and data published since mid-year point to a continued deceleration in the pace of activity, indicating that the economy is in recession. The most recent data have been very weak, pointing to a marked contraction in GDP in Q4 and suggesting that the downturn in activity could last well into the middle of next year.

The EC’s economic sentiment index, a good lead indicator of economic growth, collapsed in October to 80.4 from 87.5 in September. This was the sharpest monthly fall on record and leaves the index at a 15 year low. The index has been in decline since mid-2007, when it stood at 111.6.

Meanwhile, the composite eurozone PMI fell to a record low of 43.6 in Octoberfrom 45.3 in September, well below its peak of 57.8 in June 2007. The October readings for both these indices, if sustained, point to a fall in GDP of around 0.3% in Q4. The contraction in GDP could be even greater if the indices continue to decline in the final two months of the year.

A marked fall is also evident in national surveys of business and consumer confidence, notably the Ifo index in Germany, INSEE surveys in France and ISAE index in Italy. The continuing sharp decline in these leading indicators in recent months is another sign that GDP growth is weakening further in the second half of 2008.

This is borne out by trends in manufacturing output and retail sales, which declined on an annual basis in July and August, and the marked slowdown in export growth over the summer.

The eurozone labour market has also weakened this year. The unemployment rate picked up to 7.5% in Q3 from 7.2% in the first quarter of the year. Employment rose by 0.2% in Q2 2008 compared to 0.5% a year earlier in Q2 2007. Survey data point to a continued weakening in labour market conditions. Meanwhile, inflation has started to ease, having picked up sharply earlier this year on the back of soaring food and energy prices. The CPI rate hit a historic high of 4% in July but had fallen to 3.2% by October following declines in commodity prices, especially oil. The CPI rate is set to continue on its downward path in the months ahead given the further fall in oil prices over the past month. The recession and rising unemployment will put downward pressure on core inflation. The CPI rate should decline to 2% next spring and 1% by next summer if the fall in oil prices in recent months proves sustained.

The growth in monetary aggregates is also decelerating. M3 grew by 8.6% y-o-y in September, down from 12.3% a year ago.

Growth in private sector credit slowed to 10% in September from close to 13% at end 2007.

Although declining, these growth rates are still elevated, but this may be because the current malfunctioning of credit markets puts greater reliance on banking finance, especially for corporates. Loan growth to households for example has slowed sharply to less than 4% y-o-y at this stage.

Overall, looking at the trend in the real economy, inflation and monetary aggregates, there seems little to stop the ECB from slashing interest rates to very low levels. Rates were cut to 2% in the last cycle. There is no reason why rates cannot be cut to this level again with inflation headed below 2% in 2009.

Simon Barry, Ulster Bank Capitals Markets:

ECB cuts by (only!) 0.50% as rates now headed to 2% or lower

ECB cut rates by another 0.50% today…
…this follows the 0.50% reduction in early October…
…so rates now stand at a two-year low of 3.25%, down from the recent peak of 4.25%...
…the ECB has never before cut rates by this much this quickly…
…though there was some disappointment that the cut wasn’t even bigger following the extraordinarily radical 1.5% cut from the Bank of England earlier today…
…a still highly fragile financial system and a rapidly deteriorating economic outlook provide the context for today’s move…
…while sharply lower oil prices also greatly help the outlook for inflation…
…further rate reductions are virtually certain in the period ahead including another 0.50% cut next month…
…rates now headed for previous low of 2%, maybe even lower

The ECB cut official interest rates in the euro zone by 0.5% today. Today’s move follows the 0.50% reduction announced as part of the co-ordinated global easing of interest rate policy on October 8th. ECB rates now stand at 3.25% - the lowest level in nearly two years – and down from the cycle peak of 4.25% reached in July.

The decision to cut rates was based on what Trichet referred to as the “alleviation of upside risks to price stability” – in other words an improved outlook for inflation. The improvement in the inflation picture has two clear drivers. First, the 60% drop in oil prices since July (from $147pb to $60 at present) will help produce a sharp decline in headline rates of inflation in the quarters ahead. Indeed, it looks as if HICP inflation (the ECB’s measure) could be as low as around 1.6% by next Summer, as the effect of lower oil and other commodity prices kicks in.

Second, incoming economic news, both from the euro area and the wider global economy, has been nothing short of horrendous of late. This week’s PMIs were a case in point. The October readings of both the manufacturing and services surveys hit new all-time record lows in the euro area, underlining how severe the loss in momentum has been in activity in recent months. Numbers out of Germany earlier today confirm the extreme weakness which is gripping the zone’s largest economy, with factory orders plummeting by a staggering 8% in the month of September alone – the biggest one-month fall since at least 1991. News from other major economies has also been exceptionally weak. Service and manufacturing PMIs from both the US and UK – two of the euro zone’s most important trading partners - have also collapsed in the past couple of months.

The weakness in domestic and external demand prospects featured prominently in Trichet’s statement. Notably, Trichet observed that the intensification and broadening of the financial market turmoil is likely to dampen global and euro area demand for “a rather protracted period of time”.

The global financial system has clearly been going through a period of unprecedented stress in recent weeks and months. But we can take at least some encouragement from the fact that the extreme distress in the capital markets, and the related pronounced weakness now affecting the major economies, continues to be met by an unprecedented response from policy-makers globally.

Today’s ECB move is another example of the determination of the authorities to prevent a catastrophic economic scenario. Since the ECB was formed in 1999, it has never cut rates by so much so quickly. At the beginning of the last interest rate cutting cycle in 2001, for example, it took the ECB four months to get rates down by 1%. This time they have done so in four weeks!

Today’s 0.50% move was in line with the prior expectations of most financial analysts. However, there was a palpable sense of disappointment in the markets at 12.45 when the ECB decision was announced following the extraordinarily radical 1.5% cut from the Bank of England earlier. The BoE’s decision was as laudable as it was audacious.

The ECB today missed an opportunity to deliver an even bolder move itself. But the sharp ongoing deterioration in the economic environment means that we shouldn’t have to wait much longer for the next instalment of policy easing. We expect another 0.50% cut at the December meeting, and rates look destined to get to the 2% low of the last cycle, if not even lower.

Austin Hughes, KBC Ireland - formerly IIB Bank:

• ECB cuts for the second time in less than a month.

• Rates likely to fall again in December as new forecasts will emphasise worrying scale of economic slowdown.

• Changed reality of much poorer global growth and continuing credit market turmoil argue for aggressive ECB easing.

• We think interest rates can fall to 2% in 2009 and possibly lower.

• Lower rates will offer some much needed support to the Irish economy.

As the European Central Bank had effectively pre-announced today’s rate cut, most market interest focussed on (1) the size of the rate reduction and (2) any pointers as to future policy easing.

On a day when the Bank of England delivered a dramatic 150 basis point reduction and the Swiss National Bank also surprised by announcing an intermeeting cut of 50 basis points, today’s ECB rate cut of 50 basis points may seem disappointing. Mr. Trichet did indicate that the ECB Governing Council had considered a 75 basis point reduction and also hinted that rates would fall again in December by saying that he ‘didn’t exclude that rates could fall again’. By emphasising that the December policy meeting was ‘an important rendezvous’ because of the availability of new ECB staff Economic projections, Mr. Trichet is clearly holding out the prospect of a further rate cut next month.

Why not cut by more?

We think there are at least three reasons why the ECB did not implement a bolder rate cut today. First of all, it appears at least some at the ECB still harbour residual concerns about the inflation outlook. In our comment on the co-ordinated rate cut of October 8, we highlighted the ECB’s continuing and seemingly misplaced concern about ‘second round effects in price and wage setting’. While Mr. Trichet acknowledged today that there has been ‘a further alleviation of upside risks to price stability’, the opening paragraph of the press statement also suggests the ECB believes ‘they have not disappeared completely’. This may reflect some differences of thinking within the Governing Council. It could also be that the ECB might be excessively concerned about the looming high profile pay deal in the German engineering sector. Some at the ECB may even feel that the global response to the current downturn threatens an eventual if distant rebound in price pressures. However, it is very difficult to square the ECB’s lingering worries about inflation with the relevant evidence emerging on the economic outlook of late.

A second argument for cutting less today and easing again in December is that it can be delivered next month against the backdrop of new ECB staff projections that will show notably poorer growth prospects and a weaker inflation trajectory. If the ECB had cut more aggressively today, the presentation of dismal forecasts next month without an appropriate policy response might have put the ECB in an uncomfortable situation Mr. Trichet is now in a position to deliver a further Christmas present in the shape of another easing on December 4^th.

Finally, it remains the case that the ECB has been very slow to recognise the scale of emerging downside risks to the Eurozone economy as well as the spill-over effect of the credit market turmoil on activity in the ‘real’ economy. Mr. Trichet emphasised today that circumstances had changed dramatically of late. However, the sharp slowdown evident in a broad range of Eurozone indicators since the middle of the year suggests a marked worsening of economic conditions that predates by some distance any impact from the failure of Lehman’s in September. Naively, the ECB seems to have believed that the Eurozone would be insulated from poorer economic conditions outside the single currency area. In addition, the judgement that ECB monetary policy and liquidity policy could be operated in entirely different directions for a prolonged period of time now looks fanciful. The implication of these errors is a slower policy response that may imply poorer Eurozone economic performance in 2009 than might have been the case as well as the possibility that ECB rates may need to fall further than if rates had been reduced earlier and not increased in July.

The ECB has fallen behind

Today’s decision by the ECB to cut policy rates by 50 basis points on the same day that the Bank of England cut rates by a massive 150 basis points underlines the relatively conservative nature of monetary policy in the Eurozone. Since the turmoil in markets began in August 2007, the US Federal Reserve has reduced it’s policy rates by 425 basis points, the Bank of England by 275 basis points and the ECB by just 75 basis points(two recent 50 basis point cuts preceded by July’s 25 basis point increase). Admittedly, Euro area rates were not initially as high as in these other economic zones but US policy rates are now far lower while UK rates are below their German counterparts for the first time since the middle of 1994. (Higher inflation, stronger growth and the greater importance of borrowing to the UK economy mean that UK policy rates have traditionally been higher than their continental European counterparts).

Of course it can be argued that the financial blow to the Eurozone economy is not nearly as severe as that to either the US and UK but we are now looking at the prospect of a severe global economic downturn that requires a forceful and speedy response.

History suggests an aggressive easing is likely

Faced with a sharp slowdown in growth and attendant downward pressure on inflation in 2001-2003, the ECB cut rates aggressively. That easing cycle lasted two years, encompassed 7 rate cuts and a fall in official rates of 275 basis points. Importantly, however, the ECB began it’s easing process a good deal quicker in the economic downswing. It is also the case that the current slowdown is likely to be a good deal more severe than it’s predecessor. Indeed, we now expect Euro area GDP to shrink by around 0.5% in 2009, the first full year decline in GDP since 1993 when activity shrank to 0.8%. Although the starting point for interest rates was notably higher in 1992, the German Bundesbank, effectively the Central Bank that ruled Europe at that time, reduced it’s key policy rates by 275 basis points in 1993. These comparisons argue the case for further sharp and speedy rate cuts even after today’s move.

Because (i) the global economy has been set on a sharply weakening path for some time (ii) evidence of a marked worsening of Eurozone economic conditions has been accumulating since the middle of the year and (iii) the financial market turmoil intensified sharply in September/October, we don’t think incremental changes to policy can be justified.

The ECB has now cut rates by 100 basis points in less than a month but we think further near term easing is likely. The current episode is more worrisome than the period surrounding the 9/11 terrorist attacks when the ECB reduced rates by 125 basis points in a little over a two month timeframe. As a result, we look for another 50 basis point cut in December and further easing through early 2009 that takes the main ECB refinancing rate down to 2 per cent by the middle of next year. The current economic downturn looks like being a good deal more severe than the slowdown that triggered the drop in ECB rates to 2.00% in 2003. We think the speed and extent to which money markets return to normality and the extent to which governments use fiscal policy to boost activity will determine whether a new all-time low will be seen in ECB rates in 2009.

What about Ireland?

The evidence of the KBC/ESRI Irish Consumer Sentiment Survey suggests that changes in interest rates are of critical importance to consumer confidence in Ireland. This is scarcely surprising. We estimate that every 1% drop in interest rates will boost the spending power of Irish personal borrowers by about €1.5 bio. Of course, there is some offset as personal savers will suffer a hit of about half this amount. However, as borrowers tend to have a higher propensity to spend then consumers, the prospective drop in interest rates alongside cheaper energy and food should provide some support to consumer spending in the coming year.

While it might appear that the Irish economy’s close relationship with interest rates is a relatively new one, history suggests otherwise. Periods of significant reduction in borrowing costs tend to be followed by stronger economic growth. Clearly, the sharp drop in interest rates that occurred in the late ‘80s contributed significantly to the subsequent economic upturn.

Similarly, lower rates coincided with an improvement in Irish economic fortunes in the aftermath of the currency crisis. The approach of EMU also saw growth accelerate as did the drop in borrowing costs between 2001 and 2003. This is not to say that interest rates are the key determinant of the performance of the Irish economy. However, a more favourable interest rate climate in 2009 may leave the outlook for growth a little less threatening than is now feared.

source: irish financial news

Rory Vanucchi

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