ECB Keeps Rate at 4.25% Even as Recession Looms

Oct. 2 (Bloomberg) — The European Central Bank kept interest rates at a seven-year high today to curb inflation, even after the credit crunch forced governments to bail out banks and increased the likelihood of a recession.

ECB policy makers meeting in Frankfurt left the benchmark lending rate at 4.25 percent, as predicted by all 58 economists in a Bloomberg News survey. The bank will cut borrowing costs in February next year, another survey shows.

The financial crisis reached new heights in Europe this week as governments stepped in to help rescue five banks and credit costs soared to records. With the euro-region economy on the brink of a recession and retreating oil prices pushing down inflation, the ECB may have more room to lower rates.

“The risks to growth are clearly mounting and that means over the medium term that risks to inflation are easing significantly,” said Nick Kounis, chief European economist at Fortis in Amsterdam. The chances of the ECB “cutting interest rates in coming months have increased sharply.”

ECB President Jean-Claude Trichet holds a press conference at 2:30 p.m. to explain today’s decision. Marks & Spencer Group Plc, the U.K.’s largest clothing retailer, today urged the Bank of England to cut interest rates, saying it would “give confidence to consumers.” The BOE, whose key rate is currently at 5 percent, next decides on borrowing costs on Oct. 9.

Fed Seen Cutting

There’s a 58 percent probability that the Federal Reserve will lower its key rate by half a point to 1.5 percent on Oct. 29 and zero chance it won’t cut at all, according to Fed funds futures.

Banks have recorded almost $600 billion in writedowns and losses tied to the U.S. mortgage market since the start of 2007.

Fallout from the crisis that drove Lehman Brothers Holdings Inc. into bankruptcy on Sept. 15 hit Europe this week, with France, Belgium, Luxembourg and the U.K. rescuing lenders and Italian Prime Minister Silvio Berlusconi pledging to prevent losses for depositors.

With credit markets freezing as banks refuse to lend to each other, the ECB has injected billions of euros and dollars into the banking system. That hasn’t stopped money-market rates surging.

“It could well be that the ECB will cut rates earlier than expected,” Stephan Rieke, an economist at BHF-Bank AG in Frankfurt, said in a Bloomberg Television interview. “The economic and the financial environment have deteriorated to such an extent that we could see a rate cut of 50 basis points.”

Inflation Risks

Still, Trichet said on Sept. 30 that the ECB remains focused on fighting inflation. There’s a “clear separation” between interest-rate policy and liquidity provision, he said.

While crude oil prices have retreated 31 percent from a record $147.27 a barrel on July 11, they’re still up 23 percent over the past year. Euro-region inflation slowed to 3.6 percent in September. The ECB aims to keep the rate below 2 percent.

Some labor unions are pushing for bigger wage increases to compensate workers for the higher cost of living. In Germany, Europe’s largest economy, the IG Metall labor union representing 3.2 million workers is seeking 8 percent more pay, the biggest increase in at least 16 years.

Inflation in Europe is “still too high,” said Marc Stocker, director of economics at the Brussels-based BusinessEurope lobby group, who used to work as a forecaster at the ECB. “Inflation needs to come down fast for growth to pick up. The slowdown in Europe this year was mostly related to high commodity prices, not banks refusing credit,” Stocker said.

`Dominant Force’

Trichet “will continue to stress that upside inflation risks remain the central bank’s primary concern,” said David Mackie, chief European economist at JPMorgan in London.

He nevertheless expects the ECB to cut rates in December. “At some point the dysfunction in the financial system becomes so great that it becomes the dominant force driving” the economic outlook, Mackie said.

The ECB’s preferred gauge of five-year inflation expectations today slumped to 2.52 percent from 2.66 percent.

Companies may be reluctant to raise prices as the economy of the 15 euro nations shows few signs of recovering from a contraction in the second quarter.

The manufacturing, services and retail sectors all shrank for a fourth month in September and confidence in the economic outlook is the lowest since the slump following the Sept. 11 terrorist attacks in 2001, according to the European Commission.

Investors have fully priced in a cut in the ECB’s key rate to 4 percent by December, Eonia forward contracts show.

“We do not expect the ECB to suggest that a rate cut is imminent,” Gilles Moec, an economist at Bank of America Corp. in London, said in a research note to clients. “However, we expect the ECB President to state that the economic downturn will be deeper and longer than the Governing Council thought.” Trichet may “explicitly mention the rate-cut option,” Moec said.

To contact the reporter on this story: Simone Meier in Frankfurt at smeier@bloomberg.net

Last Updated: October 2, 2008 07:57 EDT
By Simone Meier

Source: Bloomberg

Leave a Comment