ECB rate cut speculation needs clarification

Economics: A few months ago the only debate in the financial markets about euro interest rates was the timing of the first rise.

Some analysts felt that the European Central Bank (ECB) would not tighten monetary policy until 2006, but the majority view, as expressed in the futures market, was for a quarter point increase in the final quarter of 2005.

Sentiment has swung significantly since then, however, and the market is now giving a 60 per cent chance to a quarter point rate reduction by year end, which would take the repo rate to 1.75 per cent.

Events in Europe but outside the euro area are partly responsible for the change. Sweden cut rates in the past week, by half a point to 1.5 per cent, bolstering expectations that the ECB would follow suit.

Conditions in Sweden are quite different, it has to be said, not least because inflation there is virtually zero, as against 1.9 per cent in the euro area, but this did not stop the bandwagon rolling.

Similarly, rate cut sentiment was boosted by the news that two of the nine members of the Monetary Policy Committee in the UK voted for a rate cut in June, a decision which has convinced the sterling market that British rates will fall by half a point over the next six months or so.

Domestic euro factors also played a part. Economic growth in the euro area continues to disappoint, dashing hopes of a return to the above-trend expansion required to make any impact on the unemployment malaise infecting the larger economies.

True, the euro zone area did expand by 0.5 per cent in the first quarter, which is probably around its potential or trend rate, but this was solely due to a fall in imports, with domestic demand showing zero growth.

The performance of Italy was particularly dire, with output falling by 0.5 per cent, following a similar decline in the final quarter of 2004.

The subsequent data releases covering April and May were generally weak, and growth in the second quarter in the euro area will probably emerge at 0.3 per cent or so, with manufacturing particularly soft.

Against this backdrop the market seized upon news wire reports that the ECB had now become much more concerned about the growth outlook, particularly following new price highs in the oil market, and was considering a rate cut, or at least prepared to debate the issue.

These reports, quoting "ECB sources" are a common feature of late, but are often at odds with official pronouncements from the governing council of the bank, particularly the formulaic press conference which follows the monthly policy setting meeting.

So the markets' enthusiasm for a rate cut was tempered somewhat by a stream of ECB speakers pouring cold water on the idea of a rate reduction, arguing that rates are low anyway, and that any impediments to growth in the euro area are structural in nature, relating more to high government deficits and rigidities in labour markets.

The "rate cut" stories therefore beg the question as to whether they are complete nonsense, or that there is a faction within the governing council willing to embrace a rate reduction in order to boost consumer and business confidence. Ironically, since the story appeared the data have generally been better and confidence appears to have turned up again anyway, perhaps reflecting the euro's fall against the dollar.

So the question may become redundant if the better trend in the data continues.

The ECB also faces a monetary problem, one shared by many other central banks, including those who have cut rates or are contemplating doing so.

Money is unusually cheap in Europe, and indeed across the globe, and has been for some time, which has fuelled rapid monetary growth, boosted household borrowing and contributed to an international rise in house prices.

The ECB is one of the few remaining central banks which pays explicit attention to money creation, stating that 4.5 per cent annual growth in the money supply is appropriate.

This target has been exceeded for the past four years, however, resulting in cumulative "excess" monetary growth of over 10 per cent, which for some council members is a warning of inflation to come.

Mortgage lending too, is growing at a double-digit pace in the euro area, and this average figure includes Germany where lending is stagnant, so in most countries household debt is accumulating at a rapid clip.

The combination of strong monetary growth alongside weak economic growth is also a recipe for a currency fall, so the risks to the euro/dollar are on the downside.

All told then, it would be a surprise if the ECB did cut rates in the absence of another lurch down in business and consumer confidence.

In fact, the best policy response to the current economic situation probably lies on the fiscal side, but that too is not clear-cut given the constraints of the stability pact.

Dr Dan McLoughlin is a chief economist at Bank of Ireland