ECB under growing pressure to cut rates

FRANKFURT - Agence France-Presse

The Frankfurt skyline is seen from the meeting room of the European Central Bank (ECB) council meeting room on the 41st floor at the construction site of the new headquarters of the ECB during a guided media tour in Frankfurt, Oct. 31. REUTERS Photo

The heat is on the European Central Bank to cut rates amid growing deflationary fears in Europe, but analysts are divided over whether it will act as soon as this week.

The annual rate of inflation for the 17 countries that share the euro slowed unexpectedly to just 0.7 percent in October, the lowest rate in four years, raising fears the single currency area may tip into deflation - a vicious circle of falling prices, wages and output.

RBS economist Richard Barwell, who like many other ECB watchers had previously been expecting eurozone interest rates to remain on hold at their current record low of 0.50 percent for the time being, said the data will “be sufficient to force the governing council into action.” The rate-setting council holds its regular monthly policy meeting on Nov. 7. Barwell pointed to recent comments by Belgian central bank governor, Luc Coene, who sits on decision-making body.

Coene had said that the low level of inflation was a “growing concern” and “if core inflation or inflation would continue to drop further, that in itself in my view would already be sufficient reason to think about strengthening the accommodative stance of policy.”

“When the objective of policy is to keep inflation below but close to 2.0 percent, there comes a point where inflation is so weak and coming in weaker than anticipated that the case for loosening policy becomes too hard to resist,” Barwell argued.

Deflation can slow sales

Deflation is bad for the economy because it can lead consumers to delay purchases in the expectation that prices will fall.

Slower sales have a knock-on effect on orders to factories, which reduce production and then either cut wages or jobs. This leaves households in an even worse position and then often fearful to spend, worsening the cycle even further and creating a vicious circle that feeds upon itself. But other analysts were not so certain that the ECB will act this month.

“The ECB is not generally influenced by individual monthly data but by the medium-term inflation,” said Commerzbank economist Joerg Kraemer.

“However, updated inflation projections will not yet be available at Thursday’s meeting. Consequently, the ECB can be expected to do no more than emphasize its basic willingness to act but to refer to the December meeting, when its new projections will be published,” Kraemer said. Capital Economics economist Ben May agreed that a rate cut “remains off the table.”

But Howard Archer IHS Global Insight believed that the sharp slowdown in inflation “means that a rate cut to 0.25 percent “is now a very real possibility” this week.

Such a move could also exert some welcome downward pressure on the euro, the expert argued.
“However, the ECB may prefer to hold fire until its December meeting when it will have available the new eurozone growth and inflation forecasts. Either way, we expect the ECB to cut interest rates before the end of this year,” Archer insisted.

Rise in euro may derail economy

Economists at BNP Paribas likewise warned that a protracted rise in the euro - it recently broke the threshold of $1.38, its highest level in two years - “might derail the already fragile economy”, as well as add to the downward momentum on inflation.

“In this case, action would necessary. However, we do not expect a move as soon as (this week),” they argued.

Another possible avenue of action would be for the ECB to pump more liquidity into the markets in the form of more long-term refinancing operations (LTROs), which it used at the end of 2011 and the beginning of 2012 to avert a possible credit crunch.

Draghi specifically raised such a possibility at the ECB meeting last month.

Commerzbank’s Kraemer believed a new LTRO would be the preferred route of action for market players and economists.

But some ECB council members - notably executive board member Benoit Coeure and German central bank chief Jens Weidmann - harbored reservations about such a move, Kraemer noted.