ECB Press Conference: Several Messages Sent

ECB President Trichet implied in Q & A that rates would not be lowered again at the February meeting, which is only three weeks away. Today's cut of 50 basis points took account of a likely further growth slowdown at the turn of 2008 and 2009 as well as associated diminished risks to inflation. The meeting on March 5, when new information and new staff forecasts will be available, is another matter. Does this verbal guidance absolutely rule out a rate cut in February? Not really. Recall that at the December 4th press conference, Trichet had suggested that the Governing Council would prefer to pause and assess the effects of its easings in the fourth quarter.

Medium-term risks to inflation are now deemed to be "broadly balanced." That's a new admission. Officials in December moved closer to such an assertion, saying the risks "are more balanced than in the past." Remaining upside risks include a possible future upturn in commodity prices and stronger-than-assumed domestic price pressures. Downside risks include further reductions of commodity prices and a deeper-than-assumed economic downturn, and they seem more plausible than the enumerated downside risks. Inflation of 1.6% year-over-year will continue falling in the near term, perhaps moving below zero around midyear, but such is expected to rise during 2H09. Much of this volatility will stem from base effects. Monetary policy will not react to such base-effect distortions but rather only to perceived changes in the path of underlying inflation.

Trichet acknowledges the obvious fact that growth will be weaker than staff forecasts released in December. Projected 2009 GDP then was centered on a drop of 0.5%, which now looks too high by 1.0 to 1.5 percentage points according to private forecasts. The recession, which Trichet blames largely on global factors, will be protracted over coming quarters. A basis for eventual recovery rests on the response to policy stimulus and a boost to real disposable incomes from lower inflation. There is no discussion about rising unemployment, loss of asset wealth, difficult financing conditions, and very weak consumer and investor confidence, all of which will act to keep private consumption and investment very weak.

Money and credit expansion continue to retreat, which fortifies the confidence of officials that consumer price inflation will be within acceptable boundaries in the medium term. The level of uncertainty surrounding monetary developments and all other aspects of the growth and price forecasts remains "exceptionally high." This is a nice-sounding phrase that says little. Officials have never declared uncertainty "exceptionally low" and never will, and knowing that policymakers are confused about what the future will bring hardly inspires confidence that they have the correct interest rate settings. In current circumstances, it's hard to defend rate levels that are not at all-time lows, and the new 2.0% refinancing rate merely matches a level maintained for seven months during 1999. The promise to anchor expected inflation at below but close to 2% was reiterated, but since such is said at every press conference, likewise loses any market impact. One could argue that by not having rates already at record lows, officials are gambling unduly with the possibility of sub-target medium-term inflation. It appears that officials may be guarding against a liquidity trap, wherein rates fall near to zero and remove scope for further easing. History shows that conserving potential rate reductions to avoid reaching zero is usually a flawed strategy.

Larry Greenberg
CurrencyThoughts