Fed Eases, ECB Pauses

• Preemption. The Fed has reacted to the appreciably higher growth risks. In a unanimous vote, it slashed the Fed funds target rate by 50 bp to 4.75%. Its objective is to forestall a drastic economic slowdown. The public sector will also undertake steps in this direction and acknowledge the changed financial market environment (pages 4-7).

• Repression. Inflation fears therefore took a back seat, however, were not buried. The Fed once again stressed the inflation risks. The persistently strong global demand is driving primarily energy and food prices worldwide to record levels. This will put considerable pressure on inflation rates in the coming months (pages 8-9). Prices at this year’s Munich Oktoberfest are also rising markedly again (page 12).

• Data dependency. Nevertheless, the Fed will likely ease another 25 bp in Q4. Moreover, if the data continues to deteriorate, contrary to expectations, it will undoubtedly ease further rapidly. The ECB has interrupted its tightening cycle due to the financial turmoil. Curing the causes of the crisis will take more time. And as long as a sustained normalization is not assured, we now expect the ECB to stay on hold – presumably until the middle of next year. Depending on the health of the eurozone economy at that time, the ECB will act correspondingly (pages 2-3).

• Further topics:
  – Japan: Uncertainty following Abe’s resignation (pages 10-11).
  – Bank of England: Drop of tightening bias (pages 13-14).
  – Data outlook: US consumer confidence stabilizes; Ifo weaker.
  – Market outlook: EUR-USD continues to trade higher.

ECB: A long pause ahead

The ECB has been quite clear in indicating that the rate hike has been postponed, not cancelled. This position is driven by the bank’s positive view of the eurozone economy, and by its assessment of the roots and unfolding of the ongoing financial turmoil. The ECB in its latest monetary policy meeting reaffirmed its long-standing assessment of the macroeconomic situation, where “strong fundamentals…support a favourable medium-term outlook for real GDP growth” and where inflation risks remain tilted to the upside, not least because of the vigorous money and credit growth. Monetary policy, therefore, remains on the accommodative side. An unambiguous indication that, were it not for the financial turmoil, the bank would have hiked rates again. The dislocation in financial markets, however, has heightened uncertainty and given rise to strong downside risks to the growth outlook, which the ECB duly recognized in its decision to keep rates on hold.

The question is therefore how long the pause is likely to last. Here we have to consider two things. First, while this week’s larger-than-expected 50 bp rate cut by the Fed has had a strong invigorating impact on the markets, it is too soon to say that the worst is over, and it will take time to dissipate uncertainty and resolve the crisis. On the one hand, markets are much more confident now that the Fed will provide whatever monetary support is needed to keep the economy afloat; and the rate cut should provide the US financial sector with much needed oxygen to start working out the excess leverage -indeed, 3-month libor rates dropped significantly following the Fed’s decision. On the other hand, however, unwinding and unbundling structured assets, conduits, SIVs and other positions will take time, especially as markets remain heavily dislocated, leaving financial institutions without the benchmark of market prices; moreover, with housing set to impose a prolonged drag on activity, any further signs of weakening, especially on the labor market, could quickly hurt consumer and business sentiment.

Second, the ECB has demonstrated a very pragmatic attitude in its response to the crisis. It has been prompt and proactive in providing liquidity to the banking system, first overnight and then at term. Trichet even indicated that the bank might consider widening the range of collateral which it accepts at its discount window. And it has given up on a rate hike that it had already very clearly signaled. Given this, we would expect that the bank will maintain a very prudent attitude. Before hiking rates again, we believe the bank would want to be sure that financial markets have normalized, and that the turmoil has left no significant adverse impact on the eurozone’s growth outlook. And given the unusually high level of uncertainty, we think the ECB would need to see stability prevail in financial markets for an extended period of time before feeling confident that the normalization can be sustained. This suggests that the ECB will stay on hold at least for the next two quarters, and probably through the first half of next year. By that time the current financial crisis should have come to an end, and if the European growth cycle were to be still pointing upwards, the ECB would resume tightening.

Note that the more aggressive stance adopted by the Fed might paradoxically accelerate the ECB’s approach to another rate hike. To the extent that US monetary easing supports global growth and helps the financial sector work out its imbalances, it might increase the ECB’s confidence that Europe can weather this financial crisis with minimum damage.

The trend in the EUR will also play a key role in shaping the path of eurozone monetary policy. The common currency has strengthened further, both against the USD and in real trade weighted terms. A gradual, moderate appreciation of the exchange rate naturally brings about some tightening in monetary and financial conditions, and could therefore substitute for rate hikes. To the extent that an appreciation is slow, exporters should be able to adjust to it, and the ECB would be able to rely on the exchange rate for a mild deflationary impulse. Should the appreciation accelerate in a disorderly manner, on the other hand, the ECB might find itself in a more difficult position.

Developments in the European financial system will be another key factor to monitor. The ECB’s pause has been driven first and foremost by the need to carefully assess the health of the eurozone’s banking system, especially after a few smaller banks were found to have excessive levels of exposure to the subprime market. With activity in the interbank market still nearly frozen, the risk of a credit crunch is still present. Before hiking, the ECB would therefore need to be sure that the financial sector’s problems and vulnerabilities have been transparently brought to light, and that the system itself is robust enough to deal with higher rates.

We are therefore changing our ECB call, and we now see rates on hold through the middle of next year - although we recognize that, should financial markets normalize fully and convincingly by year-end, the bank might look for a hiking opportunity already in the second quarter.

Finally, it is worth noting how the ECB attitude stands in contrast to that of the Fed on one side and that of the BOE on the other. Where the Fed has adopted a very aggressive stance, emphasizing the need to pre-empt a negative spillover from the financial sector to the real economy, the ECB has kept its monetary policy focus unchanged, continuing to emphasize inflation risks. This of course has been also due to the fact that the eurozone economy does not have the same direct exposure to the housing and subprime sectors as in the US. At the same time, thanks to its pragmatic approach to liquidity management, the ECB has been much more effective in ensuring stability than the BOE, whose attempt to adopt an orthodox and principled position backfired in a very dangerous and embarrassing way (see research note by Chiara Corsa). During these extremely uncertain and challenging times, the ECB’s pragmatic approach might well prove the best.

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