One Percent and beyond

The difficult bit is not really to forecast the path of European interest rates. There will be almost certainly a 50bp cut in March, and we would expect another 50bp cut in May or June, and probably no more before the summer break – unless the situation deteriorates again. The present assumption is that industrial growth is going to fall steadily throughout the first half, that the economy begins to stabilise in the summer, and rise moderately towards the end of the year. The ECB will probably be reluctant to cut interest rates into an upturn, and that would suggest that rates bottom out some time in the summer at around 1%.

What are the risks to that forecast? It is difficult to conceive of genuine upset risks, in the sense the interest rate cycle could bottom out at 1.5%. We will almost certainly have plenty of spooky news at least until June, and this would give the ECB enough time to cut. But is there a risk – or is it a promise – that the ECB might cut further?

In our view, Mr Trichet overemphasised some of the recent indicators pointing towards stabilisation. We should remember that purchasing managers indices, or Germany’s IFO, are all at extremely low levels. One should not consider the trends in those survey at decimal point level. There is always some noise in those data, which is why IFO itself takes three months of data to identity something approaching a trend. The single month of “recovery” is not really a trend – perhaps more a reflection of a short-lived optimism that accompanied Germany’s stimulus package in January. As the industrial order figures for December have shown – minus 27% year on year – this is the worst industrial downturn since the Great Depression. Judging from some of the export data from Asia, the decline in global exports is already as strong as it was during the entire Great Depression. Japan’s manufacturing sector is in free fall, and so is Germany’s, and Korea’s, and Taiwain’s, and China’s as well.

Now any ECB Watcher understands that the ECB is probably the closest you can come to a pure inflation targeter, in the sense that its main policy goal is to anchor inflation expectation at a level that is consistent with its price stability target. Some economists have argued that in crises such as these, it is imperative that a central bank dumps its target, and supports the economy. We disagree. Focus on price stability is the right way to go, especially in a crisis like this. Let us for the sake of avoiding decimal point pretensions, call the ECB’s target 2%. The main reason for cutting interest rates below 2% is to insure against inflation falling below target over a prolonged period of time, of which there is now a clear and present danger.

Identifying inflationary expectations is no easy task. Implied inflation rates from inflation futures tell us that there is no danger of deflation. On the contrary, these data tell us that the market expect a temporary fall in inflation rates, following by a quick rebound, and an increase in inflation to 2.5% by 2013, which would be above the ECB’s target. And the implied forward yield curves show 10-year rates of a little over 5% for the euro area, and around 5.5% for the US. Those data are not exactly consistent with market expectations of deflation.

But equally it would be mistaken to conclude that inflation expectations are well anchored at the 2% target. In a downturn as extreme as this one it is very difficult to be confident that the anchor will hold. The IMF has been forecasting inflation rates for the industrialised countries to fall below 1% for both 2009 and 2010. While we have no information at all that deflation is likely, there is, however, some likelihood of an undershoot of the ECB’s 2% target, while there is virtually no likelihood of an overshoot during the next two years – though there certainly is if you take an even longer-term perspective.

For that reason, cutting interest rates to 1% is a relatively risk-free option, provide the ECB stands ready to raise interest rates later should inflation expectations begin to rise above the target. The data would get worse, a lot worse, for the ECB even to contemplate ZIRP, but we would not rule out that rates might come down to 0.5% if the economic situation deteriorate as we expect, in other words, if there is no discernible upturn by June or July.  And no matter what the rhetoric, if there is a danger of deflation, the ECB will go ZIRP, and it will buy government bonds.

Eurointelligence ECB Watch

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