ECB and BOE: From reality check to nightmare

For European central banks, the reality check of weakening growth is quickly turning into a nightmare called recession. October PMIs showed eurozone business confidence is disintegrating, while UK GDP shrank by 0.5% in Q3. The ECB and the BOE have been badly wrongfooted by the sudden joint collapse in both the real economy and the financial sector. This is worrisome and embarrassing for two central banks that appeared exceedingly sanguine in the earlier stages of the credit crisis—particularly the ECB, which hiked interest rates as recently as three months ago.

A weakening external environment which has sparked fears of a global recession and a frightening acceleration of deleveraging in financial markets provide a particularly adverse background. At the same time, the seemingly unstoppable plunge of commodity prices suggests that headline inflation will drop precipitously in the months ahead, with ECB now facing the risk of a significant undershooting of its target next year.

We now expect both the ECB and the BOE to front-load an aggressive monetary easing, to offset the risk of a deep and prolonged recession, support a recovery in the financial sector, and fend off mounting political threats to their independence. The ECB in  particular has put itself at serious risk with the July hike, and should the eurozone recession get worse it might face pressures for a revision of its mandate (“only one needle…”). Cutting rates fast and deep is the best survival strategy for the eurozone and UK economies, and their respective central banks.

In the eurozone, we decided to update our ECB rates forecast in the wake of recent miserable growth numbers (especially today’s October PMIs) confirming that the area has been hit in full force by a series of shocks that will drive the economy into recession territory, and in light of a radical change in the inflation outlook. We now see the ECB cutting by 100bp before the end of the year (50bp at each one of the November and the December meetings). Concurrently, we move the final refi rate target to 2.00% by June 2009 (from 2.50%).

The ongoing dramatic sell-off in equity markets, with the concurrent rally in bonds and the plunge in inflation expectations, will lead the ECB to frontload the monetary easing to try and cushion the impact of what clearly looks like the most adverse phase the eurozone has faced in its young history. PMIs stand at recessionary levels, with new orders and stocks certifying a deepening contraction of the manufacturing sector. Moreover, thanks to the sustained plunge in energy prices, we now expect that inflation will be at 2.5/2.6% already in December, before moving quickly towards a bottom of around 1% by next summer. By then, the ECB will have already brought the refi rate to our new target of 2%. We think that the dramatic weakening of the real economy combined with plummeting inflation rates will drive the Council toward an aggressive easing stance.

In the UK, the first release of Q3 GDP showed today that the recession has started and the contraction has been larger than expected– a deep and prolonged recession has now become our central scenario. We are revising down our growth projections for this year and the next: we now see another two quarters of contraction in Q4 2008 and Q1 2009. Afterwards, the recovery will be very tentative throughout 2009. Overall, we expect GDP to expand by 0.8% in 2008 and contract by 0.6% in 2009. Risks remain skewed to the downside. Against the backdrop of a severe recession and with UK money markets still far from normalization, the BOE will need to cut rates even more aggressively than we previously envisaged. We now see the repo rate being cut twice this year for a cumulative 150bp,and by 50bp in January – though we do not rule out two 100bp rate cuts by year-end. The bottom will be 2.50% (from our previous expectations of 3.00%).


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