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Market Sense

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Reality check

Fri, Oct 3 2008, 07:16 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

The explosions that rocked the European financial system over the last few days have shattered the windows of the Eurotower, and reality has swept in. Today’s press conference marked a decisive shift in the ECB’s stance towards a much more realistic assessment of the balance of risks. Trichet emphasized that the Governing Council had discussed the potential impact of the extraordinary financial turmoil on inflation and growth, and determined that upside risks to inflation had diminished—albeit not disappeared—while growth was decelerating due to contracting domestic demand and tightening financing conditions. Moreover, he noted further signs of moderation in money and credit growth. While the decision was unanimous, the Council discussed the option of cutting rates, and Trichet repeatedly emphasized that the ECB can act at any time. Trichet appeared visibly more relaxed than in previous occasions: I believe he is much more comfortable with the new stance, and I think a rate cut will come soon—we are changing our call to a first cut in November (25bp) followed by four more cuts, taking the Refi to 3.0% by September 2009. I also see a meaningful chance of surprise coordinated rate cuts by ECB, Fed and BOE as soon as Monday, to compound the confidence-boosting impact of the approval of the TARP (assuming it is approved). Over the weekend, we may also see European governments announcing that “mini-TARPs” in different forms are being considered at the national level to stabilize the European financial system. With the US under siege, its financial system seriously wounded, its economy limping, and its reputation and credibility severely tarnished, European policy makers have so far appeared scared of stepping up to the plate. Their reaction until a week ago smacked of hubris and complacence. This has now been shattered, and the time for action has come—European leaders this weekend need to send a strong signal.

Today’s press conference marked a decisive change of direction for the ECB. The last few days have seen four European banks saved by government interventions, many more under heavy pressure, and Ireland’s extraordinary step to guarantee all deposits and debt of its six largest lenders. It’s been a shocking reality check for everyone, and the specter of a vicious downward spiral of financial conditions and economic growth has now taken a very definite and concrete shape in everyone’s mind.

Trichet today rose to the occasion; his message was clear, sharp, focused—an important step towards re-establishing a credibility that was at risk of crumbling.

Anchoring inflation expectations and delivering price stability in the medium term remain the paramount objective, as a prerequisite for economic growth, job creation and financial stability. In this respect, the ECB is not lowering its guard, and reiterated its vigilance against possible second round effects, given that unit labor costs have increased and key wage negotiations are still ongoing—and with headline inflation still high.

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Published on  Fri, Oct 3 2008, 07:21 GMT