Trichet May Overcome Reluctance to Cut Rates as Slump Deepens

By Simone Meier

Jan. 15 (Bloomberg) -- The European Central Bank will cut interest rates today to counter the deepening recession, even after President Jean-Claude Trichet signaled a reluctance to move this month, a survey of economists shows.

ECB policy makers meeting in Frankfurt will lower the benchmark lending rate by half a percentage point to 2 percent, according to the median of 60 forecasts in a Bloomberg News survey. That would match the lowest rate since the ECB took charge of monetary policy in 1999. The bank will reduce the rate to a record low of 1.5 percent in March, another survey shows.

Trichet said last month there’s a limit to how far the ECB can cut rates and has refused to give any signal for January, suggesting he favors a pause. At the same time, data show the economy of the 16 nations sharing the euro is slipping deeper into recession as the global financial crisis hurts exports, damps spending and swells budget deficits across the region.

“There’s no other option but to lower rates further,” said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London. While it’s “highly unusual” for Trichet to refrain from signaling a cut, “I’ve reluctantly moved away from paying attention to ECB rhetoric and started to focus more on the economy,” Cailloux said.

The ECB announces its decision at 1:45 p.m. and Trichet holds a press conference 45 minutes later. The ECB is lagging counterparts such as the U.S. Federal Reserve, the Bank of England and the Swiss central bank, which have reduced borrowing costs aggressively as the world’s largest economies slide simultaneously into recession for the first time since World War II.

Close to Zero

The Bank of England on Jan. 8 cut its main lending rate to 1.5 percent, the lowest since the bank was founded in 1694. The Fed last month lowered its key rate to a target range of zero to 0.25 percent. Japanese and Swiss rates are also close to zero.

The ECB has reduced its benchmark by 175 basis points since early October. Trichet told journalists on Dec. 15 the bank was focused on making sure those reductions flow through to the economy. It wants to avoid being “trapped” with rates that are “too low,” he said. Executive Board member Juergen Stark said on Dec. 10 the scope for further moves was “very limited.”

The faltering economy is pushing up bond yields in Italy, Spain and Greece, making ECB rate cuts less effective.

Standard & Poor’s yesterday lowered Greece’s sovereign credit rating one notch to A-, saying the financial crisis has “exacerbated an underlying loss of competitiveness in the Greek economy.” The ratings of Ireland, Portugal and Spain are also under threat.

‘Original Thinking’

European confidence has plunged to the lowest on record and the unemployment rate rose to 7.8 percent in November, a two-year high. The German economy, Europe’s largest, may have contracted as much as 2 percent in the fourth quarter, the country’s statistics office said yesterday. That would be the biggest slump in more than two decades.

“It was clearly the original thinking to keep rates on hold, but the Governing Council will find it very hard to resist a cut in the face of such extreme economic weakness,” said Julian Callow, chief European economist at Barclays Capital in London. “This meeting is one of the hardest to predict -- they could go 25 basis points, 50 basis points, or keep rates unchanged.”

Some council members have signaled they see leeway to lower borrowing costs further. ECB Vice President Lucas Papademos and council member Vitor Constancio both said this month that lower rates may be warranted if inflation falls too far below 2 percent, the bank’s definition of price stability.

The rate declined to 1.6 percent in December.

‘Too Optimistic’

The ECB last month forecast inflation would average 1.4 percent this year and 1.8 percent next year. It predicted the economy would contract 0.5 percent in 2009 before rebounding to expand 1 percent in 2010.

Those projections are “far too optimistic,” said Cailloux. “The economy could be three to four times weaker than suggested by the ECB last month.”

The shadow ECB council, a group of economists that monitors the central bank, on Jan. 13 called for a full percentage point cut. A worsening recession increases the risk of “excessive disinflation” and this should be as much a concern to the ECB as inflation above its target, the economists said.

Investors expect the ECB to lower the benchmark rate by at least 50 basis points today and to take it to as low as 1.25 percent by June, Eonia forward contracts show.

“Economic activity is falling off a cliff, inflation has crashed through the 2 percent floor of price stability, while unemployment is rising significantly,” the European Trade Union Confederation said in a statement yesterday. Another interest-rate cut is “the only sensible thing” for the ECB to do.

To contact the reporter on this story: Simone Meier in Frankfurt at smeier@bloomberg.net

Last Updated: January 14, 2009 19:00 EST