Why interest rates will fall to 2% or below by next summer
At the time of writing we do not know yet the official reading for eurozone GDP in Q3 2008. If it’s negative, as it seems, it would be official that the ECB hiked rates in July with the economy already in technical recession. Since the beginning of the year, I have been arguing that rates were heading lower because the real economy was bound to experience a severe downturn in consequence of the financial crisis and its heavy toll on the aggregate demand. As a matter of fact, the ECB hiked rates in July, triggering a very detrimental further tightening in financial conditions. After the Lehman collapse (Trichet explicitly mentioned Sep 15 as a key date in the financial crisis), the situation became unbearable and a decisive and combined global rescue plan has been put in place by fiscal and monetary authorities across the globe. The ECB’s U-turn and the euro depreciation will alleviate a bit the sickness, but won’t be enough to prevent the first year of negative growth since the inception of the single currency.
In my view, despite the 100bp of accommodation delivered in the last month, the ECB remains behind the curve - at least this is what our survey-based Taylor rule tells us. However, irrespective of any methodological analysis, it’s safe to say that the courageous move by the BoE on November 6 had left the ECB with more room for manoeuvre. Instead, the November press conference will be remembered as a missed opportunity in the same vein as those of June and July represented a monetary policy mistake. An unnecessary focus on inflation – accompanied by the usual remarks on second-round effects, upside (?!?) risks to inflation etc. – diverted the attention from the real risks the eurozone economy is running at the moment, the most dangerous being to enter a prolonged recession lasting until 2010. In my view, this remains a tail risk – I keep seeing an acceleration after the 2009 downturn – but an underestimate of the peril may bring about catastrophic consequences. Even the monetary analysis surprised with some overly sanguine remarks on credit developments. Trichet explicitly stated that up to September there were no indications of a drying-up in the availability of bank loans to households and non-financial corporations. Again, on this issue I think that the jury is still out because official lending data remain heavily at odds with what emerges from the Bank Lending Survey (and, I would add, anecdotal evidence), and because until the end of September the situation of the banking sector looked more or less manageable. I portend an acceleration in the pace of the credit slowdown, otherwise the efforts by almost all governments to secure a decent financing in favor of final borrowers would be unjustified.
Truly, both at the press conference and in some following occasions, Trichet clearly admitted that rates may be cut further. I think that another 50bp rate cut at the December meeting is a done deal. Afterwards, much will depend on how the debate within the Council shapes up, given that the urgency of frontloading the monetary easing doesn’t seem fully shared. Some members favored a 25bp easing in November; hence the aggressive accommodation I am penciling in is not a foregone conclusion. A central forecast for inflation below 2% in both 2009 and 2010 would, in my view, play a greater role in favor of an aggressive stance rather than a very bearish number for 2009 GDP. The ECB needs to play by (its) book, as it is always preoccupied to remind us. Even in Frankfurt, everybody knows that next year growth will be disappointing – most likely negative. However, with the slowdown taking care of core inflation, if commodity prices keep suffering from the global downturn, then a significant leeway for much lower rates may open up, thanks to a steep fall in headline inflation in the coming months and low inflation expectations.
At this juncture, it is impossible to forecast correctly how far down the refi rate may go. There is not a theoretical floor that cannot be crossed south. In the past, the central bank lowered rates to 2% in a less unfriendly growth framework. Plus, the aggressive easing already undertaken by the Fed and the BoE largely neutralizes the inflation risks for the eurozone stemming from a possible exchange rate depreciation. I acknowledge that a below-1% policy rate is tricky for a central bank that formally targets only inflation, but the ECB should cut rates aggressively in the near term because the growth outlook is much bleaker than they have envisaged so far and because the plunge in inflation expectations allows such an aggressive response. The sooner the better.
Beyond December, I expect the central bank to cut rates to 2% by next June. Risks to this call are on the downside, given the size of the downward revision in our GDP forecast for next year (now seen at -0.7%) and the steep inflation fall that lies ahead. The publication of the December staff projections will be a milestone to gauge how far the ECB is willing to go. An aggressive easing is a necessary but not sufficient condition to restore confidence in financial markets and in the capacity of the economy to get out of the woods relatively quickly. The ECB knows that the interest rate and the bank lending channels will not be completely effective in months to come, and their complete functioning may be restored mainly thanks to government intervention. However, at the same time a steady downward path for interest rates accompanied by a consistent rhetoric allowing for the possibility to move rates further down should inflation expectations remain well-behaved may help the hampered cycle, in accordance with the price stability objective.