ECB on the eve of an aggressive easing

– The eurozone growth outlook continues to deteriorate. The economy may have avoided a technical recession in Q3, but a negative GDP reading in Q4 seems very likely. The recovery in the course of 2009 will be only tentative.

– Concurrently, CPI perspectives have brightened considerably: thanks to plunging energy prices, headline inflation will probably fall very close to 1% next summer and below 2% on average in 2009.

– The ECB has room to cut rates aggressively. We expect two 50bp cuts before the end of the year, and the Refi rate down to 2% by mid-2009.

Environment turns recessionary.

The eurozone growth outlook is worsening by the day. The economy probably merely avoided a technical recession in Q3 – for which we continue to forecast flat growth – but business surveys for October suggest that growth momentum has weakened further at the beginning of Q4. Now virtually all indicators point to a GDP contraction in the final quarter of the year. In October, our Composite PMI plunged to an alltime low of 45.6, consistent with a GDP contraction in the 0.1-0.2% neighborhood. The EC economic sentiment index and the OECD leading indicator point to a similar-sized drop, while only the €-coin indicator – which is closely watched at the ECB, so far remains consistent with flat quarterly growth.


For the time being we confirm our view that Q4 GDP will shrink by 0.1%, but we now see downside risks to our estimate. Strictly speaking, the quarterly GDP profile we have in mind doesn’t imply a technical recession, as we forecast zero growth in Q1 2009 and a return to marginally positive expansion in the course of next year. However, it’s hardly debatable that now the economic environment in the eurozone is recessionary.

Broad based weakness Weakness is now fully broad based, with the manufacturing sector leading the way down. The factory PMI signals a deep recession, having reached in October the lowest level in at least 11 years at 41.3. At the current level, this indicator is consistent with a 6% annualized contraction in industrial output.

Particularly significant is the plunge in new orders to 36.2, with the new orders/stocks ratio – one of our favorite gauges to assess the health of the industrial cycle – that literally nosedived. Finally, the decline in the employment component to 44.5 (the lowest since January 2002) certifies that the labor market has decisively turned. We expect the manufacturing sector to keep shedding jobs throughout 2009.


The services PMI declined to 46.9 from the previous 48.4, amid recession fears that drove employment down to a fiveyear low and business expectations to the lowest level in the survey’s history. All in all, it’s quite safe to say that the PMIs don’t validate the ECB’s view that the business cycle hit a trough in the central part of 2008. Rather, they point to progressively deepening growth deterioration.

Inflation outlook: all clear!

Tumbling oil prices have forced us to lower significantly our HICP projections for the remaining part of this year and for 2009. We now expect Brent prices to average USD 75 pb next year, down from our previous forecast of USD 105pb. In this new environment, HICP should be up 3.4% in 2008 (vs. 3.5% previously), and only 1.9% next year (from 2.3% previously envisaged). At this stage, risks to the 2009 HICP forecast seem to be on the downside.

The revised monthly HICP profile shows headline inflation falling to about 2.5-2.6% in November/December, dropping below 2% in May 2009 and bottoming out at 1.2% in July 2009. Inflation will average 1.7% in H2-2009. Concurrently, core inflation will remain relatively sticky for the next few months, but the slowdown will become more meaningful in the course of 2009 and, most likely, 2010.


ECB: Refi rate down to 2%

Given this backdrop, as already flagged on Friday 24 October, we now see the ECB cutting rates by 50bp at the November 6 meeting, followed by another 50bp ease at the December meeting when updated ESCB staff projections will be published. The picture is now clear: the central bank knows that the financial storm has hit the real economy in full force, a GDP contraction in 2009 is a distinct possibility, and that inflation will undershoot 2% shortly.

If one has to believe Mr. Trichet when he says that ECB watchers should listen to him more than any other Council member as far as monetary policy is concerned, then a 50bp rate cut next Thursday should be considered a done deal. First, on October 19 he admitted that “we are in a period of a very, very significant slowdown in growth”. Eight days later he went further, by plainly saying that they will cut rates in November (“I consider possible that the Governing Council will decrease interest rates once again at its next meeting on 6th November”). Looking beyond November, we believe that the macro picture sketched above calls for an immediate and sizeable response. The ongoing sell-off in equity markets, with the concurrent rally in bonds and the plunge in inflation expectations, will lead the ECB to frontload an aggressive monetary easing to try and cushion the impact of what clearly looks like the most adverse phase the eurozone has faced in its young history. The financial sector is in a disastrous shape and the numbers on September lending to households and non-financial corporations are likely to prelude to what risks to be an abrupt slowdown in loan growth. While recent (more or less) co-ordinated fiscal actions have been welcome and testify of a serious governments’ effort to tackle the crisis, we still expect a tightening in credit conditions. The growth slowdown has eventually become truly global, with emerging economies experiencing GDP weakness, capital outflows (those who run sizeable current account deficits), and equity markets plunges. Especially, the crisis affecting some Eastern European countries de facto seizes some key output markets for euro area exports.

The ECB is well aware of all this and while we were pointing to the December staff forecast as the key trigger to enter the accommodation campaign, the escalation of the crisis requires an anticipated response. Trichet will tell us that they never pre-commit, that they have only one needle in their compass, that the easing has been made possible by an improved inflation outlook, and that there is need to keep in check any potential emergence of second-round effects. All true and fair enough, but communication remains an issue and it has been like that since the June meeting. The ECB needs to understand that at this juncture markets are very fragile and do not need undesired and unneeded volatility.


Anything less than 50bp, and the lack of a clear guidance on the timing of the accommodation will disappoint markets and expose the central bank to criticisms, at a time when governments think they are doing a grand effort to avoid a deep recession and need all the relevant actors on the job.

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