European Central Bank hints at rate cut

Posted in Europe , Peace and Conflict , Other | 02-Oct-08 | Author: Carter Dougherty| Source: International Herald Tribune

Jean-Claude Trichet, president of the European Central Bank, during a news conference in Frankfurt on Thursday.

FRANKFURT: Jean-Claude Trichet, president of the European Central Bank, on Thursday said that the threat to inflation in the 15-nation euro zone was diminishing, as he struck a new, dark tone about the growth prospects for the region.

Trichet's comments, which came after the ECB left its benchmark interest rate on hold at 4.25 percent, suggested that the bank is likely to cut interest rates later this year, analysts said.

"With the weakening of demand, upside risks to price stability have diminished somewhat, but they have not disappeared," Trichet said.

The decision, which was generally expected even though Trichet's dovish tone surprised observers, came as credit markets remained stalled and as European governments stepped in this week to help bail out five banks. Denmark and Ireland became the first European Union countries to fall into recession this year, and the likelihood of a broader downturn looms in Europe.

The ECB has been heavily criticized by bank analysts for not lowering interest rates by now. But the central bank has stuck to its inflation-fighting guns since the financial crisis began in August 2007 and even raised borrowing costs in July.

Nonetheless, Trichet's comments were interpreted to suggest that the ECB will be more willing to cut its benchmark rate in December, or possibly even in November. The ECB's rate-setting council has its next regular monthly meeting on Nov. 11. A decision before that would be highly unusual.

"Clearly there is a rather pronounced shift in the ECB stance that should pave the way to the central bank cutting rates," Aurelio Maccario, an economist at UniCredit in Milan, told Reuters. "The chances for a rate cut at the turn of the year are very high."

Trichet and other ECB officials have argued that they can handle drum-tight credit markets - the core problem of the crisis - through billions of euros liquidity infusions into the money markets that have grown progressively larger and more frequent. Its benchmark rate, on the other hand, helps keep inflation under control.

Inflation has eased to 3.6 percent in the year ending September, an improvement from the summer, when it exceeded 4 percent. But it is still far above the ECB's goal of close to, but below 2 percent.

Whether the ECB's tactic has been successful is open to debate. Credit costs have soared to record heights as financial companies hoard cash, and governments felt compelled to help bail out five European lenders this week.

On Thursday, Trichet shed some light on the ECB governing council's debate, saying, "Our unanimous conclusion was that we were right in maintaining rates as they are. "But we examined the two options."

He added, "We discussed extensively the recent intensification of the financial market turmoil and its possible impact on economic activity and inflation, recognizing the extraordinary high level of uncertainty stemming from the latest developments."

The argument in favor of rate cuts is that the ECB is underestimating the impact of more stringent credit on the euro-zone economy, and it will be forced to abruptly shift gears when statistical evidence emerges of anemic growth.

"It is difficult to predict the precise impact of the financial stress on the real economy," David Mackie, chief western European economist at JP Morgan in London, wrote in a research note. "Previous experience suggests that extreme financial stress can contribute to a deep recession.

The euro zone economy shrank in the second quarter, and economists widely expect it to do the same in the third, which would meet the widely-accepted definition of a recession. But signs of a severe credit crunch, unlike in the United States, are limited.

"I would argue now that the ECB needs to lower rates as soon as possible," said Paul de Grauwe, a professor at the Catholic University of Leuven in Belgium. "At the very least, that avoids the need in the future for a panicky reaction, a desperate last step. I don't think there is any reason to fear inflation."

Oil prices have plummeted from their July high of $147 per barrel to, on Thursday near $97, easing inflation concerns. A weaker global economy with less thirst for energy could push oil prices even lower, analysts say.

Investors are generally betting that the ECB will cut rates by December and that an economic recovery will be under way by the first quarter of next year. But with financial markets so chaotic, analysts were reluctant to rule out a rate cut on Thursday, or even a coordinated effort with the U.S. Federal Reserve - something that last happened 7 years ago.

"In September 2001 we saw that the ECB could react quickly," Soeren Dijohn, senior analyst at Danske Bank in Copenhagen, wrote in a research note. "Similar flexibility could be seen this time around if financial markets are perceived to be under severe strain and monetary conditions appear inappropriate.