Euroland: Towards New Lows for ECB Rates, but How Low? (Part I)
Joachim Fels & Elga Bartsch (London)
A 50 bp rate cut in June, possibly more to come ...
It’s time to up the ante on our ECB call. So far, we’ve been looking for one last ECB rate, of 25 bp in June, and for a moderate tightening cycle to commence around the end of this year. Now, we expect a bolder 50 bp rate cut on June 5, possibly followed by an additional step of 25 bp in the second half of the year, and we don’t see interest rates going up again before the middle of next year. Yes, this is a big change. But it reflects major changes in the macro environment that have occurred over the last month or so. Moreover, our gauges of the monetary policy stance suggest that the appropriate level of official rates is now significantly lower than the present level of 2.5%.
What has changed?
First, the euro economy started into the year on a much weaker footing than previously thought. On Eurostat’s flash estimate released last week, euro area real GDP stagnated in Q1, three-tenths below our and consensus expectations. In Italy, Germany, and the Netherlands, economic activity even contracted according to the national flash estimates. Second, the global economy is weaker than expected, too: SARS is taking a heavy toll on Asian demand growth, and the recent US economic data have also been disappointing. Third, but most importantly, the euro has continued to appreciate in recent weeks, and our currency team now sees EUR/USD heading above 120 during the summer. These three factors combined suggest that the outlook for euro area economic growth this year and next has worsened considerably from a month ago and that the downside risks for prices, especially in 2004, have increased markedly (see also Eric Chaney, State of Emergency Calls for Emergency Remedy, May 16, 2003).
ECB staff likely to cut growth and inflation forecasts
Against this backdrop, the ECB staff’s fresh set of macro projections to be released in June are likely to show a significantly lower growth and inflation profile for 2003/2004 than previously. After all, the ECB’s own model suggests that a 10% trade-weighted appreciation of the euro — which has now materialised since the last round of macro projections was published in early December — would dampen inflation by around 0.6 percentage points each in the first year and in the second year following the appreciation. Recall that back in December, the mid-point of the ECB’s 2004 HICP inflation forecast was 1.6%. Given that growth is likely to fall significantly short of initial expectations this year and given the euro’s rally, the ECB’s 2004 inflation forecast is likely to decline closer to 1%.
ECB’s clarified strategy would suggest a rate cut
According to the ECB’s clarified monetary policy strategy, presented at the May 8 press briefing, the Bank aims at maintaining inflation below, but close to, 2% over the medium term, mainly in order to provide a sufficient safety margin to guard against the risks of deflation. Thus, with inflation likely to be closer to 1% than 2% in 2004 on unchanged interest rates (which is typically the technical assumption underlying the ECB staff’s projections), the strategy would suggest that rates have to be lowered. However, the strategy remains silent on the size of the necessary rate cut.
Addressing deflation fears
In our view, the main argument for a bolder 50 bp rate reduction is the likely effect on expectations. Given the Fed’s recent acknowledgement that the risks in the US are skewed towards deflation rather than inflation, and given the swelling chorus of analysts and journalists painting a deflation scenario for Germany or even the euro area, a 25 bp move would probably not be sufficient to impress the markets and the public at large. It would rather be seen as another case of too little, too late and could thus even be counterproductive. By contrast, a 50 bp cut, coupled with a statement that this was aimed at preventing inflation from falling towards the deflation danger zone next year and that the ECB would do more if needed, would help to allay deflation fears and would help to drive home the point that the ECB hates deflation as much as it hates inflation.
Deflation and inflation expectations can be self-fulfilling
Note that even if the ECB council did not believe that there is a significant risk of a deflationary outcome, a 50 bp (or larger) rate cut may be called for. This is because expectations can be self-fulfilling: If a significant number of economic agents believe that Europe is falling into deflation, they will start to act on it: companies will slash employment and capex further, and consumers will postpone spending, all of which would exert downward pressure on the economy and prices. Given the difficulty of turning around deflation expectations once they have taken hold, there is a case for using stronger-than-usual measures in order to stabilise inflation expectations, even if the central bank does not believe that deflation is particularly likely.
Tune in to this Forum tomorrow for our take on where the appropriate ECB rate should be according to our home-made Wicksell rule and the popular Taylor rule. The full briefing note is available on Morgan Stanley’s |
