No time for a pause – ECB January 2009 Preview

“Yes, the ECB will cut interest rates at its January 15 meeting”. “Whether it will be a 25 or a 50bp ease remains a very close call. We stick to our 25bp forecast – introduced at a time when several Council members including Trichet were hinting at a pause – but acknowledge that a bolder move may well be in the cards and probably more useful”.

These have been the two typical answers to clients and counterparties’ FAQ after the Christmas break. After the further decline in the December PMIs, the stunning tumble in the EC economic sentiment, and the heavy drop to 1.6% posted by December inflation – that fully matched our expectations – the market has now positioned to price in a 50bp cut and so has done the latest Reuters consensus. It is really a close call and, in our view, of limited relevance given that what really matters at this stage is the ECB’s willingness to move below the 2% threshold in next months, and how the discussion within the Council will shape up once that psychological threshold is approached.

Before the Christmas break, Weber’s remarks on the possibility for the ECB to go below 2%, though smoothed out with the need to be cautious and to reverse the easing quickly when the economy recovers, were in our view a key signpost on the road to an ECB-style ZIRP for Euroland. Coming from the most visible hawk of the Council, with a privileged insight on the area’s largest economy bound to experience a severe downturn together with quickly-falling inflation, Weber’s words were in our view the final element to corroborate our idea that rates in 2009 will be much lower than 2%, likely in the 1% neighborhood. Indeed, dreadful data and HICP significantly undershooting for several months the ECB target – with the distinct possibility of some negative readings throughout the summer – will force the ECB hand until unprecedented levels. The claimed (by Trichet and others) steady-hand approach may well start in January, but then the easing campaign is bound to continue until the summer. Viceversa, should the ECB decide to adopt a more frontloaded easing, then by the spring the monetary policy easing may have already come to an end and the fiscal policy should have the gut to take the baton and do its part to take the economy out of the woods.

We are inclined to think that the ECB will proceed by small steps. True, there seems to be little point in shifting gears so sizeably just after having increased the pace of easing from 50bp to 75bp a meeting. However, please note that a move in January would represent a significant novelty given that in its decennial history the ECB has never acted on rates at the first meeting of the year, on the ground that the Christmas holidays prevented all the preparatory discussions. But this time the story is different, and the Council decision is scheduled for January 15. There has been all the time necessary to prepare the markets for another move: to this extent, limited but relevant rhetoric over the intra-meeting period has helped to pave the way for further easing. After hearing from Trichet on Dec 30 that a pause could have been in the cards in order to see the pass-through of rate cuts on the real economy (but we always thought it would take two-four quarters for rate moves to affect the cycle), Papademos, and Constancio – taking stock of the large drop in inflation -have maintained that monetary policy can be eased further in the coming months if the risk of an excessively low inflation level were to threaten mid-term price stability. The result has been a shift in expectations on the next week’s outcome. We think that the compromise between those in the Council who want to wait to see some more concrete transmission of past cuts into the economy and those who will argue in favor of an “act now and see” stance will produce a 25bp rate cut. But certainly we won’t be disappointed at all to be wrong and see the ECB cutting by 50bp. It is what the economy needs and what the inflation outlook allows for. To the contrary, a pause could be very harmful for eurozone financial conditions, because it risks resulting in a turn in the entrenched descending trend of money market rates, with the possibility of unwelcome currency appreciation.