European Central Banks Announce Co-Ordinated 50-Basis-Point Rate Cuts

This article looks in turn at the motivations and context for each of the European rate cuts. Please see our separate articles for analysis of the U.S. and Canadian decisions.

The European Central Bank

The European Central Bank (ECB) had opened the door to cutting interest rates at its 2 October meeting when it revealed that it had discussed such a move. Nonetheless, the timing of the move and the fact that the ECB cut its key interest rate today by 50 basis points to 3.75%, rather than by 25 basis points to 4.00%, is obviously a surprise, although speculation of co-ordinated central bank action to combat the rapidly growing threat to the global economy from the deepening financial-sector problems had been mounting. The various steps taken globally in recent days to try and alleviate the financial-sector crisis have had very little impact. Consequently, it is clear that the authorities now believe that co-ordinated, wide-ranging action is the only effective way of dealing with the problem.

The ECB acknowledges that Eurozone economic activity has weakened more than expected, with domestic demand contracting and financing conditions tightening. Furthermore, the ECB accepts that the downside risks to the economic outlook have intensified as a result of the heightened financial-market turmoil. Consequently, at its October policy meeting the bank considered that the fall in oil prices from their peak in July and ongoing growth in emerging-market economies "might support a gradual recovery in the course of 2009." This hardly smacked of confidence in the growth outlook, and the financial-sector problems have deteriorated markedly further since then. A number of Eurozone banks have had to be rescued or helped, credit conditions have tightened further, and equity prices have plunged.

Significantly, the ECB also considered that the upside risks to price stability have "diminished somewhat". Weakening demand is diluting the medium-term inflation risks, while broad money supply and credit growth is moderating. Even so, the ECB has continued to stress the importance of anchoring inflation expectations and setting monetary policy to achieve this. Particularly welcome news for the ECB therefore was that the European Commission's business and consumer confidence survey for September showed that consumers' inflation expectations and manufacturers' price-setting expectations both moderated significantly for a second month running. This would have helped the ECB in its decision to cut interest rates now, even though Eurozone consumer price inflation at 3.6% in September was still nearly double its target level of "close to, but just below 2.0%". Furthermore, Eurozone consumer price inflation has come down from a June/July peak of 4.0%.

The Bank of England

The Bank of England's decision to cut interest rates by 50 basis points, from 5.00% to 4.50%, is a necessary step given that the economic downturn is deepening, money markets are frozen, equity prices are tumbling, and the risk of prolonged, serious recession is seemingly growing by the day due to the serious financial-sector problems. The fact that the decision to cut rates was brought forward by a day and undertaken as part of a co-ordinated set of interest-rate cuts by several other central banks including the ECB and the U.S. Federal Reserve highlights just how serious a threat the financial-sector problems are to the global economy. In the United Kingdom, the Bank of England action is coming in tandem with the government's rescue plans for banks.

The Bank of England has long regarded tight credit conditions as a particularly serious risk to economic activity through weighing down on the consumer, business investment, and house prices. Thus, the further substantial tightening of credit conditions and higher market interest rates that are resulting from the current heightened financial-sector problems is of huge concern, particularly as it is occurring at a time when the economy already seems headed for recession. The Bank of England can rightfully justify the 50-basis-point interest-rate cut by pointing out that underlying inflationary pressures are now starting to moderate and that the recent substantial deterioration in U.K. economic activity, very tight credit conditions, and markedly increasing risk of a deep and extended downturn means that inflation could fall appreciably below its 2.0% target over the medium term.

Sweden's Riksbank

The Riksbank slashed its policy (repo) rate by 50 basis points to 4.25% in a special meeting, the first cut since June 2005. The move ends a sequence of 13 interest rate hikes from the record low of 1.5% in December 2005. The Riksbank believes that the global financial crisis is having a significant impact on Sweden, threatening to deepen the economic slowdown while moderating inflationary pressures. Consequently, the bank decided to move with the other five central banks after it felt that the financial crisis had led to "higher interest rates for companies and households, lower capital wealth and increased uncertainty". The Riksbank also claims that the interest-rate cut is warranted by recent economic developments in Sweden, while hoping that the co-ordinated action with other central banks will "increase confidence and the likelihood that it will have positive effects". Nevertheless, we believe the ongoing financial crisis was the only motivation for the timing of the interest-rate cut given that inflation still remains uncomfortably high, standing at 4.3% in August, close to its highest level since the mid-1990s. The central bank had stated in September that inflation expectations have fallen back but are still high among key economic and financing groups, suggesting that high inflation could still become entrenched in the economy.

The Swiss National Bank

The Swiss National Bank (SNB)'s surprise decision to cut its three-month London interbank offer rate (LIBOR) key target by 25 basis points to a mid-point of 2.50% (within a 2.00–3.00% range) comes only three weeks after its regular quarterly review, at which it left policy unchanged. As a result of recent market-determined three-month LIBOR rates being close to 3.00%, the degree of intended easing in Switzerland even amounts to 50 basis points, as in the Eurozone or the United States. As long ago as mid-September, the SNB had emphasised the unusually elevated level of general uncertainty, relating particularly to the “worrying situation in financial markets” and the path of global economic growth. This had indicated that the next step, following more than four years of monetary tightening, would be to the downside. The SNB decision not to wait until December but to bring an interest rate cut forward owes to the current need for globally co-ordinated central bank action in order to slow down the rapid deterioration of global financial markets observed in recent days. The central bank also repeated that it will generously supply the Swiss money markets with liquidity, and that it will closely monitor the impact of the financial-market crisis on the Swiss economy and on inflation prospects, acting “rapidly when required”.

Outlook and Implications

Looking first at the ECB, It is very possible that it will cut interest rates again before the end of the year, particularly if there is no easing in the financial-sector problems. Indeed, we expect the ECB to cut interest rates to 3.00% during 2009. This reflects our suspicion that Eurozone GDP growth will be limited to 0.4% in 2009. We expect Eurozone inflation to retreat significantly over the rest of 2008 and through 2009 as underlying inflationary pressures are increasingly diluted by muted Eurozone economic activity, softening labour markets and extended tight credit conditions. Lower oil and commodity prices as well as favourable base effects should also help matters.

The Bank of England is now expected to cut interest rates by a further 25 basis points in both November and December, taking them down to 4.00% by the end of this year. Furthermore, we would not rule out deeper cuts if there is no easing in the financial-sector problems. We also expect interest rates to come down to 3.00% in 2009, and would not be surprised if they were eventually to fall even lower. This reflects our expectation that GDP will contract by 0.4% in 2009 and that inflation will be back down to 2.0% by the end of next year. Prolonged very weak economic activity, faster rising unemployment, and extended tight credit conditions will increasingly dilute underlying inflationary pressures. Meanwhile, the recent marked retreat in oil and commodity prices will obviously help matters, although this is being countered by the marked weakening of the pound.

In Sweden, the press release did not include an assessment of future interest rates, but Sweden is set to embark on a lower repo path. We now believe that interest rates will be cut more quickly than previously expected, and could fall to 3.5% by mid-2009. Clearly, the central bank feels that lower interest rates are appropriate to ensure that inflation does not dip significantly below the target of 2% a couple of years ahead. This is partly due to lower crude oil and commodity prices, in tandem with the sharper-than-anticipated slowdown in Swedish economic growth. The central bank now feels that Sweden is struggling to cope with the prolonged and deepening global credit crisis and softer demand from both domestic and foreign markets. The bank hopes that resource utilisation measured either by capacity utilisation in industry or labour shortages will fall steadily in the next two years. In addition, it signalled that the labour market is also exhibiting a weaker trend. The central bank intends to present lower growth and inflation forecasts when the Executive Board meets again on 22 October. Currently, the bank expects Swedish real GDP to grow by 1.4% in 2008 and 0.8% in 2009. Our near-term outlook is more pessimistic, with the economy projected to expand by 0.9% in 2008 and 0.6% in 2009, according to the October interim forecast.

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