Rate cuts, falling inflation and thinking of quantitative easing

It’s ECB week. With the rate-setting Council meeting, we should get a clearer clue on where the ECB is headed and what is going to be the historical floor of the refi rate we should expect this year. Datawise, the only relevant release will be the final estimate of December HICP.

We have already written extensively on our expected outcome of the ECB meeting (52% 25bp, 48% 50bp, we wouldn’t even think of a pause), claiming that the recent miserable evidence does not allow at all for a break unless in Frankfurt are ready to run the risk of a 3-month euribor on the rise again and the euro spiking at 1.45 in a few-day time.

Yes, the delivered easing has been outstanding for eurozone standards, and in a less damaged juncture it would have been more conceivable to assess the expected feed through as Trichet himself has claimed on December 30. But that is something you want to do during a more “normal” downturn when the size of GDP contraction is, I would say, more manageable. To the contrary, here the situation is getting worse by the day and the beginning of the year has only brought pitiful news. There is no time to pause, also because the effects of the recent cuts will start showing up no earlier than the summer. Following ugly IP data in Germany, France and Spain (we suspect Italy will follow suit when it will report its number on Wednesday), and the scary collapse in German November exports, it’s becoming increasingly clear that GDP in Q4 will be a real disaster, significantly worse than the already depressed figure we had previously penciled in. Therefore, we need to revise down our GDP forecasts further. We now see Q4 2008 growth at –1% (previously –0.6%), Q1 2009 at –0.8% (-0.6%), and Q2 2009 at –0.4% (-0.3%). GDP will stay flat in Q3 and the positive sign will show up anew only at the end of the year. 2009 will be the worst year of the eurozone history with growth in the –2% area. It’s better if the Council gets accustomed to the idea that the easing they have in mind should be as frontloaded as possible and then we altogether can start pointing the finger at the fiscal policy as the only missing in action, although recent news from Germany authorize a certain relief. Nobody will miss Mr. Steinbrueck bluntly attacking those governments suffering from a sudden Keynesian folly.

On Thursday 15 we’ll get the final release of Euroland HICP. We stay with our previous forecast of 1.6% y-o-y that proved right against consensus when the preliminary figure was released. The ECB’s definition of price stability (which we put at 1.8%) should therefore be undershot for the first time since August 2007, and further large declines are in the cards. True, the analysis we carried out in occasion of the publication of our latest Compass assigned a relatively small probability to a genuine deflation scenario. However, we can’t easily dismiss the fact that our latest GDP revision took us closer to the level of economic contraction (about -2.5%) that we see compatible with eurozone core inflation falling to zero at the end of the two-year forecast horizon. While per se this would not imply outright deflation – which requires also the formation among economic players of expectations of future price declines – it would nonetheless be a big step in that direction. As a matter of fact, if the price stability concept works in both ways as explicitly stated in the ECB monetary policy strategy (http://www.ecb.int/pub/pdf/other/monetarypolicy2004en.pdf), there is a strong case to be preemptive and to bring rates further down here and now. Recent words by the usually-prudent Papademos and Constancio corroborate such an argument. As I wrote in the latest Compass, downside risks to inflation must be addressed by a Fed-style quantitative easing, although this will bring about lots of implications on the actual implementation of the strategy. With fiscal policy largely missing, and likely never-ending discussions on the future of financial supervision in eurozone, the ECB is the sole actor that at the moment bears the responsibility to minimize the deflation risk.

Finally, a recent ECB working paper (http://www.ecb.int/pub/pdf/scpwps/ecbwp989.pdf), may suggest that, even without contemplating any rationing effect induced by the ongoing deleveraging, the combined effect of the past tightening and the spike in the banking lending premium should indicate that we are at the eve of a serious slowdown in the growth of lending to non-financials that the moral suasion and legal enforcements carried by different governments across the area can only try to compensate for. Recent ECB numbers on lending tell us that the slowdown is occurring in an orderly manner. A continuation on that path would be a crucial stabilizing factor, but on the matter the jury is still out and if euroland wants to avoid the textbook credit crunch that the US economy appears to suffer at the moment, policymakers should stand ready to employ all the available policy levers.