ECB forecast change: refi rate to fall to 3% by mid-2009

with Marco Valli

● We have turned more negative on the eurozone and we revised downward our growth forecast for this year and next to take into account the worsened global scenario.

● We now forecast only 1.5% GDP in 2008 and 1.6% in 2009, down from 1.9% and 2.1% previously expected. Sub-par expansion will push the ECB to abandon its anti-inflation rhetoric and start cutting rates in Q3 this year. We then see the refi rate falling to 3.0% by mid-09.

● Before moving, the ECB will probably need more evidence that a significant downturn is underway, and more time to adjust its rhetoric without suffering a fatal blow to its credibility. Shaky equity markets pose the risk that the first move could come sooner than currently envisaged.

Rationale for a U-turn

A few weeks ago, in our 2008 outlook we argued that robust underlying fundamentals would have prevented the eurozone economy from experiencing a severe slowdown despite the deteriorated global scenario. Our baseline assumption was a temporary blip below trend in early-2008, with a re-acceleration starting in the second half of the year. The ECB would have stayed put at 4% pursuing its wise balancing act between the need to anchor inflation expectations in presence of a tightening labor market, and the acknowledgement of the downside risks to growth.

Since then the outlook has deteriorated further, particularly in the US, and stock markets throughout the world have sold off abruptly. On the other side of the ocean a recession has become more likely, and a severe downturn is a certainty. Irrespective of whether the US enters an outright recession or, as we forecast, the slowdown will be less bitter but more prolonged, it is a fact that there have been some key changes in external conditions that are leading us to revise our euro area scenario and the ECB policy outlook. As new evidence becomes available, it’s increasingly clear that we have underestimated the macro implications of the financial crisis, and that sound fundamentals are not enough for the euro area to escape a marked GDP slowdown.

Hence, we are trimming our GDP forecast for this year to 1.5%, and to 1.6% in 2009 (from 1.9% and 2.1% previously expected). With the Fed seen cutting rates to at least 3.00% and the BoE to 4.50%, the ECB will surrender and lower the refi rate to 3.00% by the first half of next year, starting in Q3-08 with risks of an earlier move if, as we argue later, some conditions materialize.

Introducing our new baseline scenario

Eurozone GDP momentum has continued to ease in the last months. After the strong 0.8% recorded in Q3 2007, growth has almost certainly slipped below potential in the final quarter of last year. Although the Composite PMI points to 0.5% q-o-q growth, hard data so far have come in on the weak side, and our GDP Tracker suggests a lower 0.3-0.4%.



Source: Thompson Datastream, UniCredit Global Research

This is an outcome similar to Q2 2007, when growth halved from the previous quarter. However, back then the deceleration was mostly driven by technical factors, and business surveys were still pointing to above-potential growth. On the contrary, now we see few reasons why growth sluggishness should not continue, and possibly intensify.

Exports: downshifting

Export dynamics will be rather adverse in coming quarters. It seems that consumption in the US has just started to weaken and the correction will be painful since there are profound imbalances that need to get reabsorbed. Private outlays may find significant, but temporary, support from the fiscal package just announced by President Bush. Besides, the below-50 reading posted by the December manufacturing ISM may be the first signal that the capex cycle has inverted. Summing up, US domestic demand should weaken significantly. In the UK – another key trading partner of the euro area – we now forecast 2008 GDP at 1.9% (down from 2007’s 3.1%), with six quarters of below-trend growth. Japan’s performance will be sluggish too, and it is highly unlikely that this year demand will accelerate in other Asian countries and/or in other emerging economies, in Eastern Europe or somewhere else. Concomitantly with the softening in global growth, an adverse price effect for exports will also be at work, given that the trade-weighted euro is up 3.7% since last June – when the ECB brought rates to 4.00% – and will probably rise further in the near term.



Source: Thompson Datastream, UniCredit Global Research

All these factors imply a sizeable deceleration in export growth that is now seen at only 3% this year, about half the pace recorded in 2007. Net exports’ contribution will return negative and drag 0.4 pp from overall growth.

Investment: the cycle is turning

Capital expenditure started softening already in the second half of last year, but only in a smooth way and from strong levels. However, the January ECB bank lending survey released on January 18 depicts a rather gloomy picture for investment, showing that the crowding out on lending activity induced by the financial crisis is already in place and will result in a sizeable credit rationing. This will take place both via lower quantities and via a higher cost of credit – the latest ECB figures show how interest rates on loans to non-financial corporates have significantly increased of late.


Source: Thompson Datastream, UniCredit Global Research

The need to “repair” banks’ balance sheets will reduce the availability of credit and in the near term growth of loans to non-financial corporates on the assets’ side of banks’ balance sheets will be kept artificially high by the re-intermediation of the unsuccessful pipeline of last year. Moreover, and perhaps more worryingly, banks attribute the tightening of lending standards not only to the effects of the financial crisis, but also to a perceived deterioration of the economic and business environment The only (relatively) good news is banks’ recognition that loan demand for fixed investment is decelerating, but not falling off the cliff – notice that loan demand as reported by banks correctly signaled the beginning of the investment upswing in mid-2005, and its peak at the beginning of 2007.

However, a forward-looking analysis leaves little room for optimism: with investment already on a moderating trend, the pace of slowdown will intensify in coming quarters due to easing exports, more difficult access to credit and deteriorating sentiment among businesses. Furthermore, the ECB survey reinforces the idea that residential investment will be severely affected by the recent turmoil, as credit standards get tighter and banks report a significant deterioration in mortgage demand. Some countries like Spain are already experiencing a fallout in construction activity, accompanied by plunging sentiment in other sectors of the economy (in January the manufacturing PMI fell below 50 for the first time since June 05). Though the residential market in the rest of the area (with the exception of Ireland) is in much better shape, the trend is certainly pointing south. A housing market slowdown after years of strong growth will probably take time to unfold: we don’t expect negative price growth for the eurozone as a whole, but we see little hope for a trend reversal anytime soon. If the investment cycle (both capex and construction) does invert, it may work the opposite way of mid-2005: this would be the first clear signal that the eurozone is experiencing a turning point in the business cycle.

Consumption: only tentative pick up

We remain convinced that a favourable wage dynamics and a supportive fiscal policy will guarantee a decent consumption performance this year, but in our new forecast framework private spending prevents the economy from decelerating more abruptly, rather than being the main pillar of a broad based recovery. True, the labour market is still doing well, and the pace of new hiring remains satisfactory – our indicator points to 0.4-0.5% employment growth in Q4 2007. But the labour market is a lagging indicator, and current robustness is most likely the consequence of above-trend growth of the previous quarters. Indeed, the pace of job creation is already slowing a bit and presumably will ease further as weaker GDP starts feeding through the labor market.



Source: Thompson Datastream, UniCredit Global Research

Appreciable salary increases (especially in Germany) should ensure that consumption holds up relatively well. However, inflation is eroding purchasing power, and in some countries – Spain again – the labour market has already turned and unemployment is on the rise. The bottom line is that a marginal consumption acceleration appears likely in 2008 – not yet in Q4 2007, when the consumption leg of our GDP tracker signals very weak growth. Anyway, if the investment cycle inverts, as we suspect, and the labour market follows suit with a lag, then private consumption will weaken again further out in the forecasting horizon. We expect consumption to grow only 1.6% in 2008, and slow to 1.5% next year.

ECB will need to cut to 3%

We think that the ECB will be forced to acknowledge the gloomier environment and cut rates before the end of the year. Our new target for the refi rate is now 3.00%, to be reached by the end of the second quarter of 2009. True, at the January press conference, Trichet underscored the bank’s total alertness on inflation risks, affirmed that at the moment they are not neutral, and that only a rate hike was considered as an alternative to the current on hold policy. Henceforth, Weber, Stark, Gonzalez-Paramo and, to a lesser extent, Draghi and Bini-Smaghi reinforced the message, but louder dovish tones were the real news of the last ten days. First Mersch, and then Wellink and Quaden have clearly stressed downside risks to growth and hinted at the possibility that growth forecasts published in December need to be lowered, something that is going to happen at the March meeting, when it will be clearer that, with inflation at a peak and growth settling below potential, the central bank will start to lean toward an easing bias. As a matter of fact, we do expect inflation to remain sticky and recede only gradually in coming months, but by year-end it should fall again around 2%, without the need for the Council to follow up on its threats. To this extent, keep in mind that only two days ago Trichet noted that “the real economy can have effect on inflation”: a soft acknowledgement that with a more pronounced growth slowdown, inflation might recede and be less of a threat sooner than the ECB currently expects.

The timing of the first cut remains extremely uncertain. The ECB still retains a tightening bias, and it will need sufficient evidence that the cycle has turned before acting. Key signposts may be very disappointing US data (strengthening the case for a prompt Fed response), a stock market free fall, or three consecutive quarters of below-trend growth at home with signs that the unemployment rate has bottomed out without excessive wage risks materializing. Our baseline scenario envisages the first move in Q3, because they need to calibrate the rhetoric and find a consensus within the Council, and such a process will require some time. Then, the ECB needs to see some comforting signal from the monetary pillar – net of the distortions that have probably altered recent readings – and in the meantime we will probably listen to the good old rhetoric about the 4% “neutral” level of rates that doesn’t hinder growth. Under our new GDP scenario, assuming a slow and steady slowdown in M3 corrected for portfolio shifts, our Taylor rule suggests that 100 bp of monetary easing may well be required.



Source: Thompson Datastream, UniCredit Global Research