• Emergency cut. Reeling global equity markets coupled with mounting fears of a US recession left the Fed no choice. After a hastily convened video conference, it slashed its interest rates by 75 basis points last Tuesday – the strongest rate cut in over 15 years.

  • Fed. While that has ultimately halted the slide on equity markets, it has not really calmed investors' nerves. The FOMC will, therefore, ease a further 50 bp at its regular meeting next week. And the 3% we have projected so far need not necessarily be the end of the road (p. 3-4).

  • Downswing. The ECB must first change its rhetoric before it can join the global easing cycle. Ultimately, however, the stronger-thanexpected economic slowdown will also see the ECB capitulate. We are lowering our EMU GDP forecast for 2008 to only 1.5%.

  • ECB. Inflation fears will, therefore, take a back seat to growth concerns. By the end of the year, the ECB will, therefore, ease by 50 bp. In spring 2009, we expect the refi rate to be cut to 3%. That is also implied by our Taylor Rule (p. 5-7 and chart below).

  • Further topics:

    – Weekly Comment: Central banks marching to different tunes (p. 2).

    – Germany: Inflation appears to have peaked (page 8).

    – Germany: Election campaign focuses on minimum wage (page 11).

    – Germany: Budget to slide back into deficit (page 13).

    – Data outlook: Basis effect slows EMU inflation; US economy posted only modest growth at the end of 2007 (page 15).

    – Market outlook: Bonds without clear direction; EUR still well supported (page 24).


Central Banks marching to different tunes

Events of this week have underscored the difference in attitude between the two major central banks: the Federal Reserve and the European Central Bank. Just as markets appeared to forcefully reject the idea of a decoupling of economic prospects, we have witnessed a decoupling of monetary policy stance on both sides of the Atlantic.

The Fed cut its target rate by 75bp in an emergency meeting convened on Monday evening, after having witnessed a dramatic plunge in global equity markets while Wall Street was closed for a national holiday. With the prospect of a large backlog of sell orders likely to hit US equity markets at the opening, the Fed announced its decision on Tuesday morning. The decision dramatically underscored the efforts which the Fed is making to react to a worsening macroeconomic environment, persistent financial dislocation, and rising risks in both the financial sector and the real economy. Inter-meeting decisions are rare, and this one came just one week before the regularly scheduled FOMC meeting; moreover, the magnitude of the cut was impressive, and was accompanied by a statement that clearly preludes further reductions, even after the target rate has already been lowered by 175 bp since September. The need for the Fed to react to the plunge in stock markets was obvious: a dramatic decline in US equities would have dealt a potentially fatal blow to US consumers, making it very difficult to avoid a full-fledged recession.

At the same time, the ECB has reconfirmed its key message that inflation risks remain predominant. While some ECB officials have indicated that the bank might have to revise downward its growth forecasts for the eurozone, overall very little was said to weaken or qualify the message after the last monetary policy meeting (January 10) when the bank indicated that the possibility of rate hikes was still being discussed.

There is a genuine and legitimate debate on what is the appropriate monetary policy response to the current predicament. First of all, it is certainly true that the European economy is not as vulnerable and fragile as the US economy, and to this extent it would be unreasonable to expect the ECB to deliver an emergency rate cut, as some commentators had argued. What is now under discussion is a monetary policy reaction to a more traditional crisis: stock market weakness driven by concerns on economic growth. Therefore, whereas the liquidity crisis on money and interbank markets had warranted a coordinated response by central banks, a coordinated action on target interest rates would not be appropriate at this stage given the asynchronicity of business cycles. Moreover, some are already accusing the Fed of going overboard overboard in its monetary policy easing: as the Fed itself keeps arguing that it does not see the US economy entering into a recession, critics argue that it simply being pushed by the markets in a series of interest rate reductions which might eventually exacerbate inflationary pressures. The Fed responds that it is rational to buy insurance against growing downside risks, and that it will maintain the flexibility to increase interest rates again quickly as soon as conditions warrant it. Given that the current crisis has been caused by an excessively long period of excessively low interest rates, the charge that the Fed is now getting ready to once again lower rates too much should not be taken lightly. We believe the Fed also shares this concern, and is hoping to see market conditions stabilize sufficiently to allow it to at least take a pause in the easing process. This might happen after next week’s FOMC meeting (cf. Research Note by Roger Kubarych), where we expect the Fed to cut rates again.

While the criticism of the Fed seems well grounded, the stance of the ECB is open to a different but equally valid criticism. The slowdown in the US, even if it does not turn into a recession, will have an impact on the rest of the world, as global stock markets have recognized. Europe will also be impacted, and the ECB needs to prepare to soften the blow. Of course, action should come only once the data justify it, but we believe the ECB will soon need to step away from its tightening bias and gradually move to an easing bias. We have revised our ECB call and bond yield forecasts accordingly (cf. Research Note by Aurelio Maccario and Marco Valli). We also believe this new scenario will limit the upside for the euro against the dollar because of both market expectations of ECB rate cuts and of concerns that the growth slowdown will hit the rest of the world and not just the US.

Equity markets seem to have reacted favorably to the Fed’s move, thanks also to news of a possible rescue plan for monocline insurers. We are not out of the woods yet, however, and need to be prepared to face additional market volatility in the coming months, also because marcoeconomic data will remain weak, and the risk of negative surprises in the balance sheets of European banks remains significant. The job of central bankers therefore remains extremely difficult, and it will be important for them to maintain a pragmatic attitude, without either giving in to panic or sticking too rigidly to a particular principled stance.