01/02/2008
Another option
Jean-Claude Trichet, President of the European Central Bank, repeatedly asserts that the ECB has just two policy options at present: to keep interest rates on hold or to raise them. However, that assertion will be strongly challenged as the European economy increasingly succumbs to the twin impact of slowing global growth and the ongoing credit crisis. At present, the market has priced in the first rate cut as far away as September, but it seems more likely that the ECB will have to consider moving long before then.
The Bank has been concerned about strong credit growth, sharply rising inflation and the possibility of ‘second round’ effects via higher wages. A clear warning was given, for example, by the German unions when they opened this year’s wage negotiations. Recent strong profits, robust employment growth and record low levels of unemployment have all bolstered the unions’ bargaining position. This is not a situation in which the ECB wants to send out the wrong signal, by cutting interest rates.
However, both events and perceptions are changing quickly. The ECB recently reported a considerable tightening of credit conditions in the wake of the credit crisis, and a weakening in both corporate and household loan demand. Central banks across the region have been slashing their growth expectations for this year, to well below trend. Add to that a collapse in investor confidence to the lowest level since 1992, and lacklustre consumer demand over Christmas, and it is clear that another policy option should soon be added to the Bank’s menu.
As growth deteriorates, so the inflationary outlook will improve. It is well known that there are lags between policy changes and the consequent impact on economic variables. It takes time for interest rates to affect demand and a further lag before the change in demand affects company’s pricing plans. In 2000/01 there was about a twelve month lag between European growth peaking, and inflation peaking. This time around, Euro-zone GDP peaked in the first quarter of 2007, so it is possible that inflation could be close to a cycle high. Even if inflation is not reined in so quickly, the clear peak in the growth cycle and the deteriorating outlook suggest that the operative twin options should now be: to keep interest rates on hold or to cut them.
Douglas Roberts, Senior International Economist at Standard Life Investments.
This was published in European Pensions on 1 February 2008
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