ECB Rate Cut Disappoints

Posted by: Jack Ewing on April 02

The European Central Bank disappointed analysts and financial markets who had predicted a 50 basis point cut in the main interest rate April 2. Instead, the ECB cut the benchmark rate only 25 basis points, to 1.25%. That’s the lowest rate in the history of the euro common currency, and probably the lowest official rate in Europe since World War II, ECB President Jean-Claude Trichet said in what seemed an attempt to console investors. He also made it clear that the ECB’s governing council could make additional cuts. “It’s not the lowest limit,” Trichet told reporters.

Still, the news was a letdown. A rally in European stocks stuttered after the decision, though most major indexes still rose compared to the previous day. The ECB also disappointed investors by postponing a decision on whether to buy corporate bonds as a way of encouraging bank lending. The central bank’s governing council agreed to decide on so-called non-standard measures at its May 7 meeting, Trichet said.

The question is why the ECB remains so cautious. One explanation could simply be technical, say analysts at Vienna-based Erste Bank. A 50 basis point cut would have required the ECB to cut the interest that it pays on deposits by banks to zero, from 0.5%, in order to maintain the current spread between the two of 1 percentage point.

It’s also tempting to see the ECB’s caution as a sign monetary policy makers believe that the economic downturn is running its course. As Trichet acknowledged, some private-sector economists are becoming more optimistic. However, he continued to give a pessimistic forecast, saying he doesn’t expect the European economy to recover until 2010, and then only gradually. He still sees risks of further shocks to the global financial system.

But Trichet also said, “there may be stronger than anticipated positive effects” from the fall in the price of fuel and other commodities, as well as from government stimulus programs. It’s possible that the ECB, with its mandate to maintain price stability, is already worried that further cuts could set the stage for inflation later on.