The ECB cut rates by 50bp, by unanimous decision, in line with the conservative expectations of a market cowed by the bank’s reluctant attitude of a month ago. The markets’ reaction was correspondingly downbeat: investors got what they expected, but they know what they expected is much less than the economy needs. Trichet however sent a very clear message: (1) the inflation target is indeed symmetrical, that is inflation should not be allowed to stay much below 2% in the medium term; (2) while the current Refi level of 2.0% matches a historical low, it is not necessarily a floor; (3) however, the ECB will stay on hold in February, with a further move possibly in March. Trichet indicated that the ECB does not want to get mired in the quicksand of a liquidity trap, suggesting the Refi will remain well above zero—but he also hinted that “non-standard” measures are possible. Still no explicit spelling out of a possible quantitative easing strategy, but it seems the possible measures—and associated difficulties—are being discussed. Of course, the fact that only 50bp were delivered today and that seven weeks will pass before any further move implies not everybody on the Governing Council is persuaded that more cuts are needed. Here my concern is that the ECB might underestimate the downward pressure that the severe recession ahead can put on core inflation, and which could keep headline inflation much below target into 2010. This in my view argues clearly for more rate cuts. A further argument for more monetary easing is the fiscal policy “Catch-22”: in the absence of a coordinated fiscal stimulus plan, if individual Eurozone governments do not expand fiscal policy, the markets worry growth will never recover, but if they do, the markets worry the area might blow apart.
There was a rather humorous exchange right at the end of the Q&A, which perfectly captures the ECB’s current attitude. It went more or less as follows:
Q: “Mr. Trichet, you keep talking of a liquidity trap, what do you mean, do you mean in a Keynesian sense?”
A: “Well, you can say Keynesian if you will, the liquidity trap is, as we know from historical experience, once you are there it is extremely difficult to get out.”
Q: “There where?”
Trichet had emphasized repeatedly that the ECB is “very keen” to steer clear of the liquidity trap, while declining to translate this into a floor for the refi rate. Faced with the disarming “There where?” question, he offered “very, very low interest rates”. The message was therefore extremely clear: 2% is not the limit, and rates could well be pushed further down starting in March, but not all the way to zero—we reaffirm our call for a bottom of the Refi rate at 1.0%.
While clear, however, the argument taken at face value is conceptually flawed: It suggests that the ECB sees a Zero Interest Rate Policy as a sort of quicksand: once you fall in, the more you struggle, the deeper you sink.
