European interest rates: Softening

The ECB's decision was trickier to predict than usual

IS THE European Central Bank (ECB) finally getting that rate-cutting religion? Recent comments by bank officials suggest that the central bank's hard line on interest rates may be softening. Members of the ECB's governing council, who decide euro-area interest rates, have been thinking aloud in the past few weeks, expressing disappointment with the growth outlook and apparent openness to a rate cut.

In the event, the governing council left interest rates unchanged at 2% at its monthly meeting on April 1st, as the interest-rate futures market (and most economists) had predicted. But all the chatter meant that the decision was less clear-cut than usual; in the past couple of years the ECB has been an almost boring model of predictability. Lately the odds against a quarter-point reduction have shortened considerably. A recent report by Thomas Mayer, of Deutsche Bank, puts the probability of such a cut by June, based on market expectations, at 57%.

The last time the bank went on a rate-cutting spree was between late 2002 and June 2003, when it trimmed rates by one and a quarter points. Before the ECB's recent hand-wringing, most economists had reckoned that nothing more was in store for a while, as long as the euro area did not fall back into recession.

The reasons why a cut looks on the cards are not hard to work out. Inflation is scarcely a worry. In pursuing price stability - its primary goal - the central bank aims to keep inflation close to 2%. The euro area's rate was only 1.6% in March. Meanwhile, the economy of the single-currency zone continues to flag. Ernst Welteke, head of Germany's Bundesbank, commented recently that “domestic demand has not yet picked up speed.” Jean-Claude Trichet, the ECB's president, indicated that a cut might be in store if consumer spending did not strengthen.

The economic recovery in the euro area still seems unusually fragile. Its GDP grew by a meagre 0.6% in the year to the fourth quarter. In March, The Economist's panel of economic forecasters revised its forecast for euro-area GDP growth in 2004 from 1.9% to 1.8%. Germany's economy grew by a mere 0.2% in the year to the fourth quarter, and France's economy by 0.6%. Many economists are forecasting little better from either of the euro area's two biggest economies this year. It is surprising that it has taken the ECB so long to think about cutting rates.

European politicians have been badgering the independent bank to ease policy for a while. The ECB has resisted, asking them instead to focus on structural reforms - painful cuts in social programmes and changes in labour laws - that would be better for long-term growth. Good advice, maybe; but with a greater readiness to cut rates, Europe's economies might now be suffering a little less.

Meanwhile, a weaker dollar has been taking its toll on European business, even though it has recently changed course and strengthened a little against the euro. Exports, on which the euro area has been relying for growth, are down. The terrorist attacks in Madrid have weakened consumer confidence.

But could a rate cut spell the end of the euro's recent strength and give the region's exporters a fillip? As Mr Mayer's report points out, the euro has already fallen by 3.5% in trade-weighted terms since its peak on January 6th. An ECB rate cut might keep the euro from rising again against the dollar in the short term. Meanwhile, the yen hit a four-year high against the dollar this week, amid rumours that the Japanese authorities have given up their intervention policy. And America is leaning on China to revalue the yuan. All this sounds good for euro exporters - although America's twin deficits still loom large and may limit any fall in the euro against the greenback.

Currency markets were jolted briefly this week by a rumour (false, fortunately) about the health of Alan Greenspan, chairman of America's Federal Reserve. Rattled by this, and by a few comments from the ECB, what would traders do if something serious did go wrong?

Article says the European Central Bank's decision on 1 April 2004 not to change interest rates was trickier to predict than usual. Recent comments by Bank officials had indicated the Bank's hard line on interest rates might be softening.

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