ECB Bends Mandate to Cut Rates

Posted by: Jack Ewing on October 08

The financial crisis has forced global central banks as well as governments to bend the limits of their mandates. The European Central Bank provided a dramatic example of that Oct. 8 when it joined the U.S. Federal Reserve, the Bank of England and several other central banks in cutting both short and long-term interest rates by a hefty 50 basis points. Morgan Stanley is already predicting that the surprise action, which brings the benchmark interest rate for the euro zone down to 3.75%, is the first of a series of cuts.

Formally, the ECB’s sole mission is to keep inflation in check. Only last week, ECB President Jean-Claude Trichet was reminding reporters of that as he answered suggestions that the bank wasn’t doing enough to avert a recession. “We only have one needle in our compass,” Trichet said after the Oct. 2 meeting of the ECB Governing Council, repeating a phrase he has used at least a thousand times. But Trichet also noted “an extraordinarily high degree of uncertainty” in financial markets, leaving open a path for the cuts if needed.

Despite some perfunctory language in the official ECB statement on Oct. 8 about “recently” reduced risks of inflation, the rate cuts show that the ECB’s focus is on containing the turmoil in financial markets. Inflation has taken a back seat.

Now the question is whether the cuts will have the desired effect. In normal times lower interest rates make it cheaper for companies to borrow. But there is also a risk that the coordinated rate cuts, and the ECB’s decision to push the envelope, will serve to emphasize how gravely concerned central bankers have become about the state of the world economy.

There won’t be any protests against the ECB’s decision, though. With financial markets melting down, no one is going to wave a rulebook in Trichet’s face. Investors are likely to applaud the ECB’s willingness to be flexible and decisive, and the willingness of central banks around the world to work more closely together than their respective governments.