Konjunktur
ECB Shadow Council discusses how low ECB rates should go

Members of the ECB Shadow Council discuss the options for the next policy meeting of the ECB Governing Council on November 6 and beyond.

Angel Ubide (Chief Economist, Tudor Investment Corporation, Wash. D.C.)

The outlook has deteriorates drastically and there is a clear need to cut rates quickly. The damage inflicted on the real economy by the last two months of financial market turmoil is deep and probably long lasting, and nasty tail risk scenarios can't be ruled out. The sharp decline in commodity prices and the weakening outlook imply a clear downside risk to price stability. At this point, lowering rates quickly should be the first line of attack to stop the very damaging negative loop from the real economy to a very weak financial system. Fiscal policy action will likely be needed as well, but it will take time to be implemented. Actions on the liquidity front are welcome, and the recent change in the auction mechanism to provide unlimited funds at fixed rates is working well, but funding rates need to be lowered - let's not forget that, despite the recent improvements, libor spreads remain rather high.

How low to cut rates? Given the recessionary dynamics that have set in, and the clear extreme risk aversion of financial markets, it looks clear that the neutral rate has fallen markedly, and could be in the neighborhood of zero or even negative at the moment. With an opening output gap but inflation still above target, I would think that zero ex ante real rates are probably appropriate for this outlook. Thus, I would like to see the key rate at around 2-2.5 percent as soon as possible, and I will probably be voting for 50bp rate cuts until we get there.

Thomas Mayer (European Chief Economicst, Deutsche Bank, London)

For the past year I have argued in vain that rates should be lowered to counter a likely severe fall-out for the real economy from the deepening financial crisis (see my voting record and comments posted on this website). Instead, the ECB hiked in July. The monetary policy error in my view will aggravate the coming economic downturn as the lagged effects of the tightening of monetary conditions in the equivalent of alltogether 150 basis points between mid-2007 and mid-2008 weigh on the economy. The ECB's U-turn and the drop in the euro will help eventually, but probably not before autumn of 2009. Meanwhile, I expect Euroland GDP to contract by about 1.5% in 2009 and inflation to drop to 1.4% in the annual average of next year. With some luck, growth will be just a notch above zero in 2010. It seems that the stock and currency markets are getting the message.

Against this background I now favour a bolder rate cut of at least 75bp (and could be easily persuaded to back a cut by 100bp). I think the refi rate will have to drop to 1.5% or lower, and I am in favour of going there in big steps. I also think the ECB should call upon euro area governments to coordinate a powerful expansionary fiscal impulse in the context of the 2009 budgets.

Elga Bartsch (European Chief Economist; Morgan Stanley; London)

Against a backdrop of rapidly falling economic activity indicators, easing inflation pressures and ongoing financial market dislocations the ECB should lower the refi rate by 50 basis points already at the next meeting rather than waiting until December. In the current environment, it makes sense to frontload the easing cycle. The ECB has shown in the past that it can act boldly if needed. Even without a fresh set of staff projections, it is clear that there are major downside risks to the growth and inflation outlook. Recent developments in emerging markets are fresh cause for concern. In addition to lowering interest rates, the ECB should continue to provide liquidity generously and lean on European governments to take additional policy action to stabilise both the financial system and the euro area economy. Given the huge uncertainty, it is somewhat difficult to argue where the current easing cycle should end. Given that the ECB never really become restrictive during its tightening campaign, given that the euro is depreciating noticeably, given that the changes in the operational framework likely amount to another 50 bp or so of easing and given that underlying inflation could prove to be rather persistent I am not convinced that the Bank should be as aggressive as in the last easing cycle – especially if the current downturn could at least partly also be reflecting a negative supply shock.

Daniel Gros (Director; Center for European Policy Studies; Bruxelles)

The financial crisis has mutated into a general economic crisis. Inflation is no longer a problem with oil at 60 dollars (and other commodities also sharply lower). Given the weakness of the economy there is also little chance that the temporary spike in commodity prices will lead to higher embedded inflation via higher of wages.Thus, the ECB should consider cutting 100 bp.

But interest movements are not the main issue at present. The European banking system is still under stress, a systemic crisis is unlikely at this point, but balance sheets weakness persists and contributes to the problems. As long as the money and inter-bank markets have not returned to normal the ECB will have to continue to support the functioning of markets by providing liquidity in different forms.

Stephen King (Chief Economist; HSBC; London)

The key question is not so much whether interest rates should fall, nor by how much they should fall but, rather, whether rate cuts of any magnitude will work. Surely the experience of the US shows that, even with bold monetary action, there is no guarantee that an economy can dust itself down and get back up on its feet. Rate cuts may help but, on their own, they won't provide a cure to the current economic malaise.Central banks' power to influence economic activity depends critically on how that power is transmitted through the banking system. The evidence from the last year or so strongly suggests that the banking cable has been cut. In effect, we encountered the zero rate bound last year not because official rates were at zero but because monetary policy stopped being effective.Bbroken banks lead to massive cash hoarding by the banks themselves, by hedge funds fearing redemptions, by companies and by households. As cash is hoarded, so risky assets are sold. Financial meltdown is the result. Injecting capital into the banking system seems sensible enough but there are some awkward downsides. First, even with additional capital, banks won't be able to go back to the old lending volumes, so cash hoarding remains a problem. Second, because taxpayers will demand help for domestic companies and households, banks' international lending will shrink which will simply redistribute credit problems from rich nations to poor nations. Third, this in turn threatens an outbreak of protectionist pressures within capital markets.

Central banks should give up pretending that their Independence is a strength. In current circumstances, it's a weakness. Like men of a certain age, they need a shot of Viagra to give them some potency. That can only come via the interplay of monetary and fiscal policy. Central banks need to deal with monetary hoarding but, on their own, they have no mechanism to get money into the economy. The ECB, along with others, should be demanding that governments monetise borrowing, because only by bypassing the banking system via government spending is there any chance that monetary policy will work again. The ECB was designed brilliantly to deal with inflation. That, though, is no longer the threat. We now are facing a financial meltdown that can only be dealt with by recognising that monetary and fiscal policy, at the limit, are much the same thing. I'm voting for a 100 bp cut at this meeting, but I think the ECB, alongside other central banks, has to go a lot further...and that means giving up the pretence that rate cuts, alone, provide the solution.

Gernot Nerb (Head of Industry Research; Ifo-Institute; Munich)

I am in favour of an immediate cut of interest rates by 50 basis points and another cut of this size before yearend as well as a continuation of the monetary easing process in the first half of 2009. There are clear signs that inflation expectations have peaked some time ago will subside further whereas the outlook for the real economy is getting bleaker. Only a quick turnaround in monetary conditions is likely to avoid a further deepening of recessionary tendencies.

Erik Nielsen (European Chief Economist; Golman Sachs; London)

I think a cut of 100 bp would be in order. The financial crisis has now spread to Central and Eastern Europe causing both additional stress to European banks’ balance sheets, but also directly to European corporates’ export markets, which takes about 15% of total Euroland export. Adding Central European weakness, both in terms of demand and their FX, to that of the US and the UK means that net exports are now likely to deliver some quarters of negative contributions to Euroland growth. Along with a near-collapse in capital expenditures, this will surely see unemployment pick up. While Euroland households’ balance sheets remain in fine shape, we know from past experience that bad news – particularly in terms of rising unemployment – tends to lead to still higher savings ratios at the expense of private consumption. This means that GDP growth is likely to remain negative during the remainder of the year, and possibly into early 2009.

With negative growth indicators, sharply falling inflation (mostly due to commodity prices, but little reversal likely due to the output gap emerging) and a financial sector that badly needs a steeper yield curve, it seems increasingly clear to me that ECB rates need to go a lot lower than their present level. My present guess is that they'll need to go to 2.0% - and the probability of them not needing to go below 2.75% within the next 3-4 months seems remote. Hence, why wait? Much better to get the ECB back in front of the curve.

Marie Diron (Senior Economist; Oxford Economic Forecasting; London)

The surprise co-ordinated cut on 8 October does not seem to have had much of an impact. Of course not on the real economy which will only react with a lag to the cut, but also not on financial markets. Euribor rates remain elevated and more generally financial markets do not show any clear sign of returning to more normal functioning. Meanwhile, economic news keeps surprising on the downside, both for the euro and the other major economies. Inflation concerns seem to be of a time long past. All this implies that another cut in interest rates is warranted this month. And the current situation calls for decisive steps, not for the 25bp moves that have been typical in the past.

How far down ECB rates will ultimately have to go is impossible to say at the current juncture. Much further down probably, but I do not think that we can be much more precise than that. I do not think that there is an intrinsic floor that the ECB should not breach. Although with the benefit of hindsight, the major central banks are now being blamed for having kept rates too low for too long in 2002/04, I think that the stress should be on ‘too long’. Reactivity is essential at the moment and the ECB should not hesitate to lower rates to or even possibly below 1% if the circumstances justify such moves. It is true however, that, once rates reach 1%, there is some rationale for not wanting to waste the last few moves. It may well be that at such low rates further cuts would be more or less ineffective. So a strategy may be to cut rates down to 1% relatively quickly and then act more slowly.

Chrisitan Bordes (Professor; Centre d'économie de la Sorbonne, Paris 1 University)

Confronted with the worsening of the crisis, central banks in general and the ECB in particular have to show in the conduct of monetary policy the same creativity and imagination as the ones they showed to ensure financial stability by the use of new intervention tools on the interbank and money markets. Due to the gravity of the situation, monetary policy must depart from the way it is conducted in normal times, in order to remain effective in a situation without precedent. Since the beginning of the year, predictions for EU’s economic growth have been regularly revised downwards and, during the past weeks, these downside risks to growth have materialized : Of course, following the ECB’s recent key rate cut, the five- year/five-year forward breakeven rate has jumped 14 basis points to 2.5 percent. However it appears that the financial crisis has eased the inflation outlook as the current impact of the sharp economic downturn on the evolution of prices is already apparent in the last business surveys. This suggests that the upside risks for price stability are on the decline with underlying CPI inflation turning more quickly than previously expected. Furthermore, one cannot totally exclude a worst-case scenario in which the pessimistic expectations regarding growth carry the economy into an extended economic slump, which would push prices and wages down just as banks restrain the flow of credit, increasing the risk of starting of a deflationary spiral.

To avoid the self-fulfilment of such pessimistic expectations, one can consider an aggressive response consisting of a supplementary 50 bp cut on Nov. 6. However, the Nov. 6 decision concerning the key rate will be less important than the communication regarding its future path. As the traditional channels – real interest rate and bank balance sheet – have certainly become ineffective due to the scope of the financial shock and will be restored mainly by fiscal policy measures, more than ever the expectations channel is the main lever for monetary policy to influence the economy. One can contemplate a scenario according to which the key rate might be reduced to 2.5 or 3 percent by mid- 2009, depending on the response in the inflation adjustment to the slowing down in economic activity. In any case, such a scenario will be accompanied with a high uncertainty and one may fear that its publication would not radically change growth and inflation expectations dynamics. Therefore, it would be more effective to supplement the decision of an immediate 50bp decrease in the key rate with the announcement that, during the next few months, it will be revised downwards until growth expectations are stabilised, while monitoring the concomitant evolution in inflation expectations. In other words, the future interest rate path would be fixed in order to stabilise growth and inflation expectations in accordance with the price stability objective.

Giancarlo Coresetti (Professor, European University Institute and University Rome III)

The question that I see as most urgent is to understand how to intervene globally in an economy with emerging widespread credit and liquidity constraints for both firms and households. Moreover, while government debt is clearly seen as safe relatively to private financial assets and intermediaries, we are aware of emerging spreads --- see the widening divide in the yields of German bunds relative to debt issued by other countries in the euro-area. As the extent of the growth slowdown will become clearer, also the fiscal stance and viability of different areas will come under closer scrutiny. In this respect, more and more central banks activity have apparent and potentially large fiscal implications, while governments initiatives affecting the banking sector can modify over night the transmission of monetary policy --- contingent fiscal liabilities are clearly making us aware of the truism that there exists only one consolidated budget.

So what to do facing with high probability a scenario of persistent credit and liquidity constraints in the years to come coupled by fiscal strain? First, obviously, rates will have to be reduced conspicuously consistent with the coming slowdown --- in a large step upfront, or in successive steps, as long as it is made clear that the central bank is committed to use its power to counteract the slowdown. Second, while the slowdown in inflation has some positive elements (especially as regards the part which is due to commodities prices), the central bank should make clear that it will counteract deflationary tension. Counteracting deflation may be tricky in possible contingencies where price tensions could be attributed to deterioration of fiscal stance, and there is always the risk of 'losing control of the nominal anchor.' But these risks should be assessed against those inherent in a slump --- especially if the data will confirm the feeling from scattered information, that in the last few weeks financial intermediation has curtailed the flow of resources to firms and households, while on the asset side households appear to believe that the only trustable assets are issued by the government. Unfortunately, we should also be aware that the contribution of monetary policy at this stage will not be decisive.

Julian Callow (European Chief Economist; Barclays Captial; London)

Having called for a 50bp last month, this month I vote for another 50bp cut. The sharp rise in the "fat tail" downside risk that I feared rising a month ago has for sure become much more visible - ie we are seeing a negative feedback loop develop between the financial markets and the real economy both for the euro area domestic economy and its trading partners. Assuming wage settlements moderate, there will clearly be scope for more easing, including in December.The inflation outlook has got much better but more especially I think that it is vital for the ECB to accompany its efforts to restore normalcy in money markets with a sharp further reduction in the policy rate, and to signal yet further easing is likely if inflation pressures continue to moderate.

José Luis Alzola (Senior Economist; The Observatory Group; Bilbao)

The latest activity and confidence indicators confirm that GDP growth probably was negative in 3Q and started on a weak note in the current quarter. Moreover, despite some easing of tensions in recent days in the money market, monetary conditions remain undesirably tight. As a result, the near-term outlook for GDP growth remains one of stagnation or a mild recession and the risks are clearly on the downside. Domestic demand indicators show significant weakness and the moderation of the global economy is intensifying, including in emerging markets. Meanwhile, the near- and medium-term outlooks for inflation are improving appreciably. In the near-term, the plunge in energy and other commodity prices will continue to reduce headline inflation rapidly in coming months, in turn diminishing the risks of second-round effects (on wages) in coming quarters. In the medium-term, below-trend growth also will lower inflation ex-energy and food (which has remained just below 2% anyway in recent quarters) further below 2%. Recent wage indicators confirm that this year’s pick-up will be contained. Monetary indicators also point to lower GDP growth. In particular, M1 growth remains close to zero and credit to households remains very sluggish. After surprising on the strong side late last year and early this year, credit to non-financial firms is (as expected) finally showing signs of moderating.

Against this background of virtual absence of inflation pressures, policy should focus on containing the economic downturn. The downside bias to policy reflects the fact that money-market rates may remain well above policy rates even after the whole set of measures implemented by the ECB and governments; in this case, the ECB should be prepared to lower rates again in the coming months.

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