ECB Reduces Key Interest Rate from 3.75% to 3.25%, Door Open for Another Cut in December

The European Central Bank (ECB) cut its key interest rate by 50 basis points from 3.75% to a two-year low of 3.25% at the conclusion of its 6 November policy meeting. This followed a 50-basis-point reduction from 4.25% to 3.75% on 8 October as part of a co-ordinated set of interest-rate cuts by several international central banks (including the U.S. Federal Reserve and the Bank of England).

The 100-basis-point reduction in interest rates from 4.25% to 3.25% that the ECB has enacted since October reflects just how markedly the Eurozone economic situation and outlook has deteriorated in recent weeks as the heightened financial crisis since mid-September has magnified already serious problems. Indeed, it is almost certainly no longer a question of will the Eurozone suffer recession, but rather, how deep and long will it be? Along with the sharp fall in oil and commodity prices, this means that there is now a very real risk that Eurozone consumer price inflation will substantially undershoot the ECB's target of "close to, but just below 2.0%" over the medium term. In marked contrast, Eurozone consumer price inflation reached a record high of 4.0% in mid-2008 and concern about the medium-term prices outlook had led the ECB to raise its key interest rate from 4.00% to a seven-year high of 4.25% as recently as July.

This latest 50-basis-point interest-rate cut by the ECB had been widely expected, given consistent evidence of sharply deteriorating economic activity and increasingly diminishing inflationary pressures across the Eurozone. Furthermore, ECB President Jean-Claude Trichet had previously indicated that the bank could cut rates again at the 6 November meeting. Indeed, the fact that the ECB limited its interest-rate cut to 50 basis points was seen in some quarters as rather timid given that the Bank of England had slashed its interest rate by 150 basis points (from 4.50% to 3.00%) earlier in the day and given the rapidly growing danger of extended, deep Eurozone recession. Indeed, latest Eurozone data and survey evidence have been generally dismal. However, the ECB's reluctance to make a deeper interest-rate cut appears to lie in its belief that upside risks to medium-term price stability have "not disappeared completely", although they have diminished significantly.

Significantly though, the ECB is clearly leaving the door wide open for further interest-rate reductions in the near term. Indeed, Trichet revealed that the ECB discussed cutting interest rates by 75 basis points at the latest meeting to 3.00%, although he indicated that the final decision to reduce them by 50 basis points to 3.25% was unanimous.  Trichet also stated that he did "not exclude" another interest-rate cut at the ECB's December meeting, although he stressed that the bank never pre-commits to future monetary policy decisions.

Although the retreat in Eurozone consumer price inflation from a record peak of 4.0% in mid-2008 to 3.2% in October has been primarily due to sharply lower oil prices and a waning of the upward impact from food prices, there are also now clear signs that underlying inflationary pressures are diminishing markedly as much weaker activity and orders dilute companies' pricing power. Meanwhile, a sixth successive rise in Eurozone unemployment in September reinforces belief that workers' bargaining power will be increasingly undermined and that this will lead to wage moderation. Importantly for the ECB, latest survey evidence shows that both companies' selling-price expectations and consumers' inflation expectations have retreated appreciably recently.

Outlook and Implications

Global Insight believes that it is highly likely that the ECB will reduce interest rates by a further 50 basis points from 3.25% to 2.75% in December, given the increasing threat of extended, deep Eurozone recession and the ongoing financial-sector problems. Furthermore, we now expect the ECB to bring interest rates down to 2.00% by mid-2009, which would match the lowest level seen since the region came into being in 1999. Indeed, there is a very real possibility that Eurozone interest rates could fall further still.

The ECB is now clearly highly aware that extended recession rather than inflation is the major threat to the Eurozone economy. This marks a significant turnaround from its stance as recently as September. Up until then, the ECB had continued to express considerable concern over current high Eurozone consumer price inflation levels and the upside risks to medium-term price stability. The bank was particularly concerned that wages would move significantly higher over the coming months because of elevated inflation and recently tighter Eurozone labour markets. Companies' pricing power and intentions, and the possibility of renewed spikes in oil, commodity, and food prices have also been significant concerns for the ECB. Furthermore, money-supply and credit growth across the Eurozone has been persistently too strong for the bank's liking.

The upside threat to medium-term price stability from all of these factors has diminished appreciably, and it seems certain to continue to do so as a result of the probable extended weakness of the Eurozone economies. Consumer price inflation has so far fallen back to 3.2% in October from 4.0% in July, while annual Eurozone M3 money-supply growth slowed to a 23-month low of 8.6% in September from a record high of 12.3% in November 2007. Credit growth is also now moderating appreciably. Meanwhile, given the ECB's keenness to see inflation expectations anchored, the bank will be particularly pleased that the European Commission's business and consumer confidence survey for October recorded a third successive, and deeper, fall in the selling-price expectations of manufacturers. Consumers' inflation expectations edged upwards in October after falling markedly over the previous three months, but at +19 the sub-index was still well down from +31 in June and below its long-term average of +23.

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