Shadow Council
Majority Vote: Rate Cut Proposal

I vote for a 50bp cut of the refi rate and accompanying rates. My vote is based on the following considerations, which contain elements of the ECB?s two-pillar monetary policy strategy but do not strictly follow it:

1. The Euroland economy grew below potential in 2001 and 2002. Most likely growth will remain below potential in the first half of next year. Although a rise to potential growth is envisaged in the second half of 2003, this forecast is subject to an unusually high degree of uncertainty. Hence, the output gap will increase further in the foreseeable future.

2. With Euroland governments rallying behind the Stability and Growth Pact, fiscal policy is likely to turn more restrictive in 2003 as larger countries will make efforts to rein in their budget deficits. Since deficit reduction is likely to be engineered to a significant extent through increases in taxes and levies, growth will suffer.

3. The euro has strengthened and is likely to continue to move higher over the next 6-12 months as capital flows to the US will probably slow. This will exert a further drag on growth.

4. Headline inflation is hovering above 2% now and will do so in the near-term. However, there are first signs that core inflation has passed its peak. The rising output gap will exert downward pressure on inflation in the medium-term.

Points (1) - (4) above suggest that upward risks to price stability are low at present and will remain so in the near future. Against that, downside risks to growth are significant. In the present environment, higher wage growth and oil prices pose a greater risk to growth than to price stability.

5. Private sector credit growth is well behaved at present, but could slow in the future on the back of weak nominal GDP growth. High money growth is due to strong liquidity preferences against the background of volatile financial markets and not indicative of an excess supply of money.

Point (5) suggests that the longer-term outlook for price stability remains equally satisfactory. Moreover, taken together with recent asset price developments, it points to very little risk of asset price inflation caused by a build-up of excess liquidity. Conclusion: Hence, both the near-term and longer-term outlook for price stability is favourable at present while growth is weak and the downside risks to growth are significant. Against this background, downside risks to price stability are likely to emerge if interest rates remain at their present levels. To have a significant economic impact, raise confidence, and stabilise rate expectations, rates would need to be lowered by 50bp.

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