• Downturn. The pressure on the Fed to act is building steadily – despite the 125 bp in cuts in January. The economy continues to slow unabated. For the current quarter, we now expect GDP to shrink. The US economy is on a razor’s edge; recession is a distinct possibility.

  • Credit crunch. In addition, there is the fear of a full-blown credit crunch: Banks have recently tightened their lending standards dramatically (cf. chart below). This is counteracting the impact of lower interest rates (pages 3-5).

  • Fed. We are, therefore, changing our Fed forecast and now expect the FOMC to lower its target rate to 2% by mid-year – 50 basis points in March and then another half a percentage point in Q2 2008. However, the risks remain skewed to the downside.

  • ECB. Trichet backed away from last month's hawkish rhetoric, and switched to a de facto neutral bias. Nevertheless, the deteriorating macro and financial market environment means the ECB will have no alternative but to start its easing cycle at the end of Q2 2008 (page 6).

  • Further topics:

    – Weekly Comment: Needle in the compass or needle in a haystack (page 2).

    – Eurozone: Manufacturing’s resistance won’t save GDP from a substantial softening (page 7).

    – Data outlook: Weak EMU growth in Q4 2007; US retail sales down in January (page 9).

    – Market outlook: Government bonds to remain well supported; EUR-USD to tread water (page 17).


Needle in the compass or needle in a haystack?

The ECB has de facto moved to a neutral bias, as Trichet awkwardly backed away from last month’s hawkish threats and implicitly admitted that the eurozone is heading to belowtrend growth with risks skewed to the downside. Trichet underscored the unusually high level of uncertainty regarding economic and financial market developments, which makes it hard to see the way ahead—the “only needle” in the ECB’s compass is now a needle in a haystack… Next month, revised staff forecasts should pave the way towards an easing bias and a first rate cut which is now likely to come by end- Q2.

The ECB has stepped away from its rate hike threats and towards a neutral stance. This is more like an awkward stumble than an elegant step, in my view, but certainly a move in the right direction.

In a merciless Q&A session, Trichet was confronted with all the explicitly hawkish statements he had made in last month’s conference: (1) Are rate hikes still on the table? (2) Does the ECB still have a tightening bias? (3) Is the ECB still ready to move preemptively to avoid second round effects on inflation? Trichet’s reaction was that of a man rather embarrassed at being reminded of rash words spoken in a heated moment. He retreated behind the cover of well-rehearsed general statements, reiterating that the ECB “remains constantly alert” and ready to do whatever necessary to ensure price stability in the medium term. He declined to explicitly characterize the bank’s bias as tightening or neutral, and cautioned that the ECB never pre-commits to a specific course of action. He did, however, state that the decision to keep rates on hold had been unanimous, implying that there had been no suggestion of a rate hike. Threats of rate hikes sounded dangerously detached from reality, and it is reassuring to know that sanity has prevailed.

The ECB now sees eurozone growth as sliding below potential. Trichet stressed that data have confirmed that risks to the growth outlook are skewed to the downside. In the January statement, the ECB said that its baseline scenario forecasted real GDP growth broadly in line with potential. Yesterday, Trichet declined to describe the bank’s baseline scenario, noting that revised staff forecasts will be released next month. In the Q&A, however, he was asked directly whether growth is already below potential. His reply was that the ECB sees “ongoing growth”, “close to potential but perhaps on the lower side” – a rather explicit admission that the new staff forecasts will see growth slipping below trend.

Though the ECB still perceives upside CPI risks emanating from high capacity utilization, a tight labor market and lack of competition in some sectors, all the references to inflationary pressures were smoothed: risks to price stability are no longer “fully confirmed”, but only “confirmed”, and he omitted to say that the ECB stands ready to “act preemptively”.

After having insisted that the supply of credit to European companies and consumers has not been impaired yet, Trichet denied that he had ever believed in decoupling, and argued that of course a significant deceleration or recession in the US would slow down growth also in Emerging Markets including in Asia. Emerging Markets could still post a healthy pace of growth, and partially offset the weaker US dynamics, but they would not remain unaffected. This is a very sensible view, and one that we can subscribe to—but the ECB statement is noticeably less bullish on the extent of this offset compared to the previous one.

The needle in the compass is now a needle in a haystack… Trichet underscored that uncertainty is unusually high, as regards both developments in the financial sector and their impact on the real economy. With the financial crisis still underway, concerns about monoliners, a more fragile world growth outlook and risks coming from commodity prices, protectionist pressures and global imbalances, with inflation reaching new highs and growth slowing down, identifying the right monetary policy strategy becomes more and more difficult. Trichet repeated that the ECB has only one needle in its compass, but with this kind of uncertainty, it seems to have become more a needle in a haystack.

Bottom line: this is an important step away from the previous hawkish rhetoric and closer to reality. The ECB has de facto adopted a neutral bias, and this is especially significant on the heels of a new high in HICP inflation (3.2%). New staff forecasts next month should pave the way towards an easing bias and a first rate cut which is now likely to come by end- Q2. This will be clearly signaled by further changes in the rhetoric – Trichet indicated that the ECB would remain predictable and strive to avoid surprising markets. We reiterate our call for 100bp of easing by H1 2009.