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26.01.2009

09:12 Uhr

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ECB Shadow Council discusses the merits of slowing down the rate cutting cycle

ECB Shadow Council discusses the merits of slowing down the rate cutting cycle Latest comment by Julian Callow

Erik Nielsen (Chief European Economist of Goldman Sachs, London)

Since the severity of the impact of Lehman became clear, I have argued for ECB rates to be cut to no more than 1.0% as fast as possible. In recent months I have judged that steps of 100 bp a month would be appropriate; I still believe this to be the case, hence my vote in February of 100 bp cut. I see no reason what-so-ever for a pause in the rate cuts at this time; the outlook for both growth and inflation remains as bleak as before, and the stress on the financial sector seems to have increased. Once we get to 1%, I believe one needs to take a new good look at the outlook with a view to assess whether rates should be cut further to 0.25%-0.5%. I have also argued for some months that the ECB should be explicit in its definition of the inflation target as being symmetric and that it would be defended as aggressively if undershot as if overshot. At the December press conference, Trichet did confirm that the target is symmetric, but (1) he did not specify what "close to 2%" means (for example, is 1.2% close enough?), and (2) he did not roll out the same aggressive rhetoric for an undershoot as he has done repeatedly for the overshoot. Specifically, I would want the ECB to make clear that ANY sign of deflation would be met with all weapons necessary, including as much quantitative easing as needed.

Marco Annunziata (Chief Economist of Unicredit, London)

At the risk of sounding like a broken record, my recommendation is again for a cut in interest rates by 100bp. Every week we get additional evidence from activity data that this is the worst recession the Eurozone member countries have faced in the postwar period. Headline inflation is set to turn negative during the summer. We know this reflects largely base effects on energy. But the sharp real GDP contraction of this year and the well below potential growth forecast for 2010 imply a significant widening of the output gap, with attendant sustained pressure on core inflation. In this environment I believe rates should be no higher than 1.0% and might well have to be pushed even lower. I see no reason for delaying rate cuts given the lags with which rate changes feed through to the real economy. Monetary easing has been initiated at a relatively late stage, with most of the cuts implemented in Q4 2008. Given a lag in transmission of 2-4 quarters, that means that only in H2 we will see any beneficial impact of the easing. Meanwhile there is no ray of hope in the data, and I therefore see no convincing argument for a pause-especially as in my view the risks to the inflation target over the policy relevant medium term horizon are clearly skewed to the downside.

I am also skeptical of the ECB?s a priori reluctance to lower interest rates all the way to zero for fear of ending up in a liquidity trap. The problem in a liquidity trap is not that interest rates are at zero, but that even with zero rates monetary policy finds it hard to stimulate activity. The priority is to revive activity and keep inflation on target, and simply keeping rates above zero out of principle will in no way help achieve these objectives. In the end, I would concede that lowering rates from say 1.0% to 0-0.25% might be immaterial, but the emphasis should then be on launching a well structured and effective quantitative easing strategy, not on keeping rates above zero. This is particularly important because the ECB faces additional complications in launching a QE strategy compared to the Fed. For example, direct purchases of government bonds will be a very delicate matter given the recent widening in spreads, and direct purchases of corporate bonds or commercial paper would be even more sensitive (whose countries? or companies? paper would the ECB buy?) The market realizes this, and as inflation continues to decline it might lose confidence in the ECB?s ability to prevent a deflationary spiral.

Christian Bordes (Professor, University Paris I)

On the activity side, the latest news for the Euro-zone economy are reasonably encouraging as several surveys (business expectations in the services sector, Belgian manufacturing survey, sentiment among some equity analysts; etc.) show that sentiment is stabilising. Whilst waiting for confirmation of this, as inflation is unlikely to fall durably into negative territory, a 25 point decline in the key rate seems appropriate.

Charles Wyplosz (Professor, Graduate Institute of International Studies, Geneva)

There is simply no good news on the horizon and no reason, therefore to keep the real interest rate positive. There is no reason either to wait because I don't see the option value of waiting. The "keep the powder dry" argument is also unconvincing, the real topic is how to do quantitative easing in the euro area. The lame solution is for the ECB to buy strong debt, in this case German debt. But the ECB could hold auctions for each country debt separately, aiming at acquiring at market rate public debts in proportion, say, of its country's GDP.

Elga Bartsch (European Chief Economist of Morgan Stanley, London)

In my view, the ECB’s intention to pause because there is only a three week lapse since the January meeting does not make much sense as most of the key data releases in the euro area are coming out in this three weeks. I think they will warrant a reduction in rates. However, iIn the light of the total fiscal stimulus in the euro area to the tunes of EUR 130 bn this year, even more substantial financial sector rescue packages and the generous liquidity provision to the banking sector by the ECB itself, at this stage, I wouldn’t view a large interest rate reduction as being warranted. The recent stabilisation in some of the forward-looking sentiment indicators seems to underpin my view of second half recovery in the euro area. Given the long-time lags before monetary policy takes effect on the economic activity and inflation, there is a risk that the monetary policy stimulus eventually becomes pro-cyclical. Since the last meeting, the broadening of the corridor pushed the EONIA overnight rate further below the refi rate, which in my view amounts to a stealth-easing of interest rates. Looking beyond the upcoming meeting of Shadow Council, I am leaning towards further easing at the March meeting.

José Alzola (Senior Economist of The Observatory Group)

There is little new information since the last meeting. In fact, the only developments are: (1) Some early signs of a stabilization (albeit at very low levels) in business and consumer confidence indicators; and (2) Continued decline in money-market rates, which will provide further relief to existing mortgage holders and firms with variable rate loans. Of course, the risks to growth remain clearly on the downside, justifying a downward bias and, possibly, additional interest rate cuts in March and/or beyond. Later this week, we will get January CPI data but they are unlikely to alter the assessment about the underlying price pressures.

Regarding whether the ECB should bring or not rates to zero, my position is that, in principle, such low rates are unwarranted unless the recession is deeper than currently anticipated and/or underlying inflation approaches zero. At present, the main problem (aside from the recession itself) is the freezing of credit, particularly to small and medium-sized firms and to households that are otherwise credit-worthy. I do not think that bringing rates to zero will solve that problem because the obstacle lies elsewhere. If the credit crunch intensifies – compounding the risk that the recession deepens – then the solution is “quantitative easing” (in the form of direct lending by the authorities to the non-financial private sector), which can be done at rates above zero. Bringing, in addition, rates to zero may only create the wrong incentives for the future when the time to raise them back again arrives.

Thomas Mayer (European Chief Economist of Deutsche Bank, London)

Recent business and some consumer surveys allow the hope that the speed of the economic contraction is no longer accelerating. Part of this may be due to expectations of further (and more decisive) policy action. Hence, we should not infer from these data that there is no need for more monetary policy support for the economy. But how large should the next cut be? I remain in favour of "measured" steps of 50bp. Monetary policy is to a significant extent also expectation management. In normal times, large rate cuts were made not least because they were expected to boost confidence. In the present extraordinary times the opposite may happen: large rate cuts may fuel anxiety. This would argue for measured and regular steps. Should we refrain from bringing rates all the way to zero? I can't see why. We should be prepared to use the entire repertoir of monetary and fiscal policy to fight the risk of deflation, and this includes bringing policy rates towards zero and have the central bank buy outright private and public debt when needed. This is a time when close cooperation between monetary and fiscal policy is needed. But the institutional set-up of EMU was not designed for such a time. We should fix this and elevate the Eurogroup to a body capable of such coordination. This will not only be important during but also after the immediate crisis, when we need to find a way to get policies back to normal.

Agnès Bénassy-Quéré (Director of CEPII, Paris)

Given recent macroeconomic forecasts (e.g. those recently released by the European Commission) I think the ECB should continue to cut interest rates as soon as possible. I would favour a 75 bp cut so as to bring the main refinancing rate to 1.25%. A 100 bp cut would bring to zero the marginal deposit rate, so the EONIA could well fall to zero too. Then, the incentive to lend liquidity would disappear. Before reaching a genuine zero interest rate, I think it is worth testing a close-to-zero policy.

Angel Ubide (Chief Economist of Tudor Investment Corp., Washington)

My argument has been all along to bring rates to zero (or marginally negative) real rates, and thus a cut towards 1 percent is warranted immediately. To go below 1 percent, we have to start discussing whether the ECB should engage in qualitative easing. At this point, the ECB can be more effective by purchasing, or engaging in longer term swaps, of collateral for which there is little liquidity, in order to kickstart lending. I don;t understand, for example, why, in the middle of a crunch where banks are having tremendous difficulties in raising funds - and while officials are asking banks publicly to lend more - the collateral conditions on covered bonds are tightened. The ECB needs to think hard about which areas of the market are the main impediment to the flow of credit, and act aggressively in those areas - and put moral hazard considerations at bay. The ECB needs to inject risk into the system, at a time when private agents are not taking any risk. The ECB has to be the symmetrical risk absorber of the cycle. If we cut to 1 percent rates are already very low. At this point, the ECB should say clearly that they expect to keep rates low for a while - in order to flatten the yield curve and thus lower longer term rates - and debate which assets they need to act on. The sudden spike in risk aversion that has led to the massive destruction of growth in Q4 can potentially be reversed by strong and prompt policy action. Otherwise, there is a risk of a very prolonged period of subdued growth. With the risks in Eastern Europe only increasing for European banks - and viceversa, as Eastern European countries are suffering from a massive outflow of capital - the outlook is very fragile. There is no point in delaying.

Julian Callow
(Chief European Economist of Barclays Capital, London)

The combination of the financial crash - and macroeconomic implications - alongside the strict focus by the ECB of an inflation definition of below but close to 2% has clearly meant that Quantitative Easing (QE) now needs to be firmly on the ECB's agenda. I recommend a further 100bp of easing in the policy rate (which, under the ECB's current framework, would imply that the overnight interest rate would trade close to zero. As well, I would like to rekindle the debate on whether the ECB in the longer term should aim to have a higher inflation target, and a broader band, since the current experience suggests that it might well need to resort to QE. .Effectively, this is a choice of the "lesser of two evils". It might be thought that an inflation rate definition higher than the ECB's might pose a risk for the efficient allocation of resources. However, if the alternative is that there will be occasional shocks which will result in the "zero interest rate bound" being hit, and therefore require a "non-orthodox" monetary policy to be implemented, then perhaps the ECB's inflation objective should be set somewhat higher. This is because we do not know how well QE will proceed. What we do know is that previous attempts in the US and UK to target outright the money base led to extreme interest rate volatility (in the early 1980s) which proved very damaging to the real economy at the time. The problem with targetting the money base is that the money multiplier is not stable - particularly at a time of financial crisis or even just at a time of recession. Therefore, in pursuing QE, central banks have no recent history to calibrate their decisions upon, and must acknowledge that they are dealing with particular uncertainty in the money multiplier.To me this suggests that QE is best avoided in theory as an option: it is better to stick with conventional tools (even though they also will suffer from non-linear relationships at a time of a shock or recession). At least we know something about how conventional tools work, rather than nothing.

In the past I have always argued in our Shadow Council discussions that the ECB should have a price stability definition in a broad band centred around 2%, eg 1-3%. However, the particular nature of the current crisis (even if it is, as Mr Trichet described it, a once in a century event) suggests to me that we should consider something centred around 2.5%, just to lessen the risk of needing to deploy QE.I am not advocating that central banks stick rigidly to a particular inflation rate point target. The experience of the US and UK shows that there are real costs involved in deploying monetary policy aggressively to try to achieve a smooth profile for the expansion in activity. In the late 1990s, we all thought there would be an imminent recession. This is because they come around every five to ten years and follow a boom - there was clearly a boom at that stage. Yet, by virtue of an extreme shift in interest rates, Mr Greenspan managed to avoid a recession (the annual rate of US GDP expansion never went negative on a quarterly basis during 2001). However, the payback for the distortions resulting from this extreme monetary policy at the time are only too apparent now, where we seem not just to be having a "double recession" (to make up for the lack of the recession that would normally have materialised eight years ago) but worse still. Indeed, I wonder if the monetary experience of the past fifteen years might cast attempts at monetary "fine tuning" to try to attain a stable headline inflation rate in as equally unfavourable light as we now regard fiscal "fine tuning" in the 1960s. Essentially, extreme cuts in the short term interest rate to bolster demand, which rely for their effect largely on influencing myopic borrowers to take on debts they will not be able to service, is hardly a recipe for sustainable long-term expansion. [Incidentaly, I do not think that tighter regulation would necessarily have made so much difference for countries where central banks were very activist in seeking to keep headline inflation very close to a particular point target: it might have resulted in yet more-accommodative monetary policies in recent years as these institutions sought to keep inflation closely in line with their target].

Concerning the near-term outlook, however, I continue to advocate that the situation we are in is so negative for activity and therefore for inflation, that aggressive monetary easing remains warranted. This may well take the ECB ultimately into a conventional form of quantitative easing. The evidence from January is that conditions in the industrial sector have continued to worsen sharply from those exceptionally weak levels in Nvoember and December. Already a record amount of slack has opened up in the euro area economy and this will depress strongly the core inflation rate unless policy can deliver an early turn-around. I do not think the fiscal stimulus plans go far enough for monetary policy to be able to slow down the pace of easing at this stage. A collapse in activity of this magnitude warrants a collapse in rates. In this case, I am advocating an ultra-easy monetary policy not to encourage myopic borrowers to become yet further indebted, but rather just to cushion the impact of such a severe economic collapse.

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