The ECB’s interest rate conundrum: To cut or not to cut?

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The GDP-weighted PMI (my calculation) of the Eurozone is pointing to a significant drop in the year-on-year GDP growth to between 1.0% and 1.5% in the third quarter from my estimated 2.3% to 2.5% in the second quarter.

Sources: Markit; Dismal Scientist; Plexus Asset Management.

Furthermore, the IFO business expectations index that leads the GDP-weighted PMI by around two months indicates further weakness in the GDP-weighted PMI in August and September. That certainly does not augur well for the Eurozone economy as it points to a further slump in the fourth quarter of this year.

Sources: Markit; Dismal Scientist; Plexus Asset Management.

The slump from 2.5% growth in the second quarter to probably below 1% in the fourth quarter is reminiscent of that of 2008 when the growth rate fell from 2.1% in the first quarter to 0.4% in the third quarter. In 2008 the ECB hesitated and commenced lowering the repo-rate only in October that year.

Sources: I-Net Bridge; Plexus Asset Management.

That was despite important primary indicators such as the GDP-weighted PMI dropping below 50 for three consecutive months, thereby indicating a contraction in the Eurozone economy.

Sources: Markit; I-Net Bridge; Plexus Asset Management.

In 2006/2007 the ECB’s focus was on reigning in economic growth by raising the repo rate despite low inflation. In 2008 the ECB was obsessed with fighting oil-price-driven inflation rather than focusing on the economy as a whole. In fact, the ECB continued to raise the repo rate despite clear evidence that the CPI inflation rate had topped out. The ECB only started lowering rates when both the GDP growth rate and inflation tanked.

Sources: I-Net Bridge; Plexus Asset Management.

At this stage it appears that the inflation rate has topped out and that a new downtrend is emerging. Will the ECB soften its monetary policy by lowering the repo rate in light of the inflation rate rolling over and the economy nose-diving?

It seems to me that the ECB has room to lower the repo rate and the real repo rate to the crisis levels of 2009.

Sources: I-Net Bridge; Plexus Asset Management.

I do think the ECB’s actions will be very restricted, though. If the oil price (Brent spot) remains at 76 euro for the next few months, it will again exert upward pressure on the CPI inflation rate. Rising inflation in turn will lead to a lower real repo rate. That leaves the ECB with the decision of whether to keep the repo rate unchanged to stimulate the economy or raise the rate to quell inflation expectations.

Unless the economic situation elsewhere in the world improves significantly and change the outlook for the Eurozone economy dramatically, I trust sanity will prevail and the ECB will not err on the conservative side as it did in 2008 by waiting too long. Otherwise the double whammy of higher interest rates and austerity measures in the PIIGS countries are going to have severe implications for the entire Eurozone economy. I will not be surprised to see a cut of 25 basis points in the not too distant future.

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