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The European Commission issued a weak first-quarter outlook last Wednesday, indicating that Eurozone growth could be between -0.2% and 0.2% — a relatively deep double dip. So the ECB's 50 point cut is a better choice than 25 points given the non-inflationary level of the euro and the weakness of the European economy. This was the first rate move by the ECB since November 2001. European financial markets seesawed a bit on the announcement, with bond yields up some. And the euro initially weakened, then recovered. This makes sense, given that Europe is at a stage where bigger rate cuts make it more attractive, not less. In general, the market reaction indicates that the ECB is in a reactive mode, and therefore the rate cut is simply a response to the latest economic slump. The ECB pointed to expectations of lower inflation in the near term as justification for lowering rates. The most recent inflation reading was 2.2% for the year through November, still above the 2% ceiling. It's an improvement if the ECB consistently begins to use inflation expectations rather than actual inflation to guide its monetary policy. It would be even better if the ECB began to focus on core inflation and to use the exchange rate as one of the key inputs into the inflation outlook. In his press conference following the rate decision, ECB President Willem Duisenberg stated, "The assessment which guided today's monetary policy decision was that, overall, the prospect has strengthened for inflation to fall below 2% in the course of 2003 and to remain in line with price stability thereafter." The subtext to the decision is that Eurozone GDP growth is clearly unacceptably slow. In fact, of the major economies, Eurozone GDP thus far in 2002 has been the slowest. Even Japan's GDP growth over the first three quarters of this year has exceeded that in the Eurozone. Duisenberg continued to emphasize the importance of structural reform in revitalizing the Eurozone economy, implying that monetary policy can't do it all and may have done all that it can. He said, "We note with some concern the slow progress in many euro area countries [in implementing structural reforms] and call on governments to take determined action." As was the case in the recent action by the U.S. Federal Reserve, it appears that the ECB wanted to take an aggressive action in an attempt to squelch market expectations that further cuts were in the offing. Expectations of further rate cuts can actually delay economic activity as market participants wait for the cut to occur. In the press conference, Duisenberg was asked if the cut "would clear the air for some time to come." He responded, "I can answer that in the affirmative." This exchange implies that Duisenberg, like Greenspan, does not anticipate the consideration of further rate cuts for some time. The ECB's 50 basis point rate cut will help. Still, Europe's growth rate depends more on Iraq, U.S. growth, and European structural reforms. — Mr. Malpass is the Chief International Economist for Bear Stearns. |
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European Central Bank finally cut interest rates late last week —
by 50 basis points. That was a welcome surprise from the stubborn, inflation-targeting
central bank.
