European Central Bank looks while Fed leaps

Europe’s hopes of avoiding the aftershocks from an economic downturn in the US took a blow this week.

Such was the state of panic on Tuesday (22 January), as stock markets faced up to the prospect of a US recession, that the Federal Reserve Board announced after an emergency meeting that it was slashing the policy interest rate, the so-called Fed funds rate by three- quarters of a percentage point (75 basis points) from 4.25% to 3.5 %, stark testimony to both its growing fears about the economic outlook and to the impact that a stock market panic could have at a time when financial market confidence remains so vulnerable.

Ben Bernanke, the US Fed chairman, had told the House of Representatives Budget Committee on 17 January that "the baseline outlook for real activity has worsened and the downside risks to growth have become more pronounced".

Some private sector economists were already concluding that even this was too optimistic a view. "The US economy is slipping into its second post-bubble downturn in seven years…this recession will be deeper than the shallow contraction earlier in this decade," remarked Stephen Roach, chairman of US investment bank Morgan Stanley Asia.

Until more is known about the depth of the now emerging US and Japanese downturns and the health of Europe’s big banks, it will be difficult to assess how sharply a slowdown will hit Europe.

As far as the banking sector is concerned, the quarterly survey of bank lending standards published by the European Central Bank (ECB) last week (18 January) was particularly discouraging and another factor behind the stock market melt-down in Europe on Monday (21 January). According to Citibank economist Jose Alzola, the survey’s evidence of tightening lending conditions for firms and households in the Euro area, especially for mortgages, "confirm the existence of downside risks to growth on the domestic side". This raises "serious doubts about the ECB’s hope of a consumption recovery this year," he added.

Recent official forecasts for the EU have generally erred on the optimistic side. In its autumn economic outlook in November 2007 the Commission predicted that growth in 2008 would fall in the eurozone to 2.2 % from a healthy 2.6% in 2007. Significantly, however, the Bank of Italy last week (15 January) slashed its growth forecast for 2008 from 1.7% to 1%. Even some ECB council members, including Nout Wellink, president of the Dutch central bank, are warning that official forecasts are too optimistic. He seems to share investment bankers Lehman Brothers’ view that the 2008 growth figure for the whole eurozone could be nearer 1.5%.

In Europe, the recent hawkish hints from the ECB President Jean-Claude Trichet that the ECB might even raise interest rates always needed to be taken with a pinch of salt. Trichet believes that, with inflation running at 3%, against its 2% target, the ECB should not cut interest rates, especially as imminent wage negotiations in Germany, France, Italy and Spain could help to embed higher inflation expectations in the eurozone economy.

But the ECB’s stance, says a senior EU economic policy official, has to be seen in a broader perspective. Trichet has watched Wall Street’s investment banks effectively hijack monetary policy from the Federal Reserve and set interest rate expectations in the US. He certainly does not want the ECB, too, to lose control of monetary policy expectations, to the markets or the politicians. Equally, the ECB does not want to be pressured by the example of the Fed’s aggressive rate cuts into lowering eurozone interest rates prematurely.

Now that the resilience of the EU economy is being thrown into doubt and the Fed has acted so aggressively, the demands for the ECB to lower rates will intensify.

Without clear signs of inflation falling or growth declining the ECB will still be inclined to resist the pressure and be in no rush to ease Europe’s monetary policy. Once again, however, after its success in so quickly responding to the fall-out from the subprime crisis, the judgement of Europe’s still relatively new central bank is going to be put to the test.

• Stewart Fleming is a freelance journalist based in Brussels.

Europe’s hopes of avoiding the aftershocks from an economic downturn in the US took a blow this week.