Don't Count on the ECB to cut interest rates

Within minutes of last week’s rate cut by the Federal Reserve , market analysts predicted that the European Central Bank would have to do the same. When the US sneezes – you know the rest.

It is not going to happen. The ECB may cut interest rates at some point, though I would not bet any hard currency on this. One of the most important reasons historically for monetary union in Europe was to become less dependent on the US. Today, monetary policy in Europe is geared towards domestic targets. If the ECB cuts, it will happen because of firm evidence of a fall in domestic inflationary pressures.

Some central bankers have even advocated a rate increase. If there is concrete evidence that the most recent spike in headline inflation rates is translating into higher wages, that may still happen. Most probably it will not. But the prospect of a rate cut is just as remote.

When making decisions, the ECB relies on two distinct judgments. The first comes in the form of a quarterly staff forecast for growth and inflation. The December ECB staff projection has inflation in a range of between 1.2 and 2.4 per cent for 2009, which is broadly in line with the target for inflation of below but close to 2 per cent. The projection is based on some optimistic assumptions, for example a fall in raw material and energy prices this year. On the basis of the present staff forecast, there is no case for a rate cut at this point.

The ECB is also looking at other indicators, such as confidence surveys. Purchasing managers surveys have recently pointed towards a downturn. But last week’s increase in Germany’s Ifo index suggests that the German economy remains robust. So even the forward-looking indicators are not producing a consistent signal of a downturn ahead.

The second judgment comes in the form of a quarterly monetary analysis. This is not old-school “monetary targeting” but a mixture of statistical methods and judgmental analysis. It has influenced the debate at certain times, for example in late 2005, when the ECB began to tighten policy at a moment when the staff forecast did not suggest it was necessary. There were other periods when the influence of monetary analysis was less important, for example at the beginning of this decade, when its message was relatively opaque.

This is not one of those times. Today, the monetary analysis tells us loudly and clearly that inflationary pressures have been building up in the economy. It is not just the prolonged double-digit rise in M3, a broad money-supply measure, that worries the ECB. What is quite puzzling is that credit generation in the eurozone has remained extremely buoyant right until the end of November. We will get the December data later this week, and that may change the assessment. But as of end-November 2007, the financial crisis has had no discernible effect on actual credit flows.

Take, for instance, loans to households. They rose by an annual, and unsustainable, 9.4 per cent in 2005, by a still unsustainable 8.2 per cent in 2006, and by a still respectable 6.5 per cent for the year until last November. The monthly flows also remained robust in all the important lending categories.

An analysis of the consolidated balance sheet of the monetary and financial sector in the eurozone suggests that the eurozone banking sector is not only healthy, but continues to supply the economy with ample funds. This may change at some point, but for now it would be wrong to say that the eurozone labours under a credit crunch. It does not.

This January’s bank lending survey did produce some evidence to the contrary. Banks have tightened credit lines to enterprises and to a lesser extent to households since the start of the financial crisis in August. But it is important to put these survey results into some perspective. The period until the second quarter of last year was characterised by an unsustainable lending boom. A tightening in lending standards is not only inevitable but highly welcome. What really matters for the economy as a whole are the actual financial flows, which are not showing any signs of ebbing. For as long as the money freely flows, do not expect the ECB even to contemplate a rate cut.

The eurozone is in many important aspects different from the US and the UK. There has been no fall in house prices. There is no subprime crisis. There are no monoline insurers. There is no pandemic of overstretched borrowers. While there are clearly some distressed banks, the European banking sector is still robust, the odd rogue trader notwithstanding. The eurozone is also in a fiscally strong position to confront a downturn.

Of course, the transatlantic financial markets are deeply integrated, as we saw again last week. A deep and long US recession will affect the eurozone too. At the same time, the overused “catching-a-cold” metaphor no longer accurately describes the complex interactions of the global economy.

Send your comments to munchau(at)eurointelligence.com

The Financial Times Limited 2008

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