As widely expected, the European Central Bank's (ECB) governing council unanimously voted to keep its key interest rates unchanged on Thursday.
The council's decision was fairly easy as both Eurozone inflation and money supply M3 growth have reversed direction recently, coming off their record highs seen earlier this year. ECB president Jean-Claude Trichet said there had been a discussion in the council about a rate cut, but continuing inflationary dangers tilted the Eurozone central bankers towards maintaining the status quo which appears to be the right medicine now. The Euro fell to a new 2008 low at $1.3770 as soon as Trichet repeated his growth concerns, which had sent the Euro markedly lower after the last ECB meeting in September.
Eurozone inflation has declined to 3.6% in September after 3.8% a month earlier. M3 growth receded to 8.8% in August, after 9.1% a month earlier.
In his economic analysis in the introductory statement Trichet started out with renewed warnings about a possible contraction in the Eurozone stemming from declining domestic demand that could turn down further.
As the world economy as a whole is feeling the adverse effects of the intensified and prolonged financial market turmoil, the most recent data clearly confirm that economic activity in the euro area is weakening, with contracting domestic demand and tighter financing conditions.
Inflation still tops the list of concerns despite encouraging latest figures as Trichet saw second round effects through rising unit-labour costs.
With regard to price developments, annual HICP inflation has remained considerably above the level consistent with price stability since last autumn, standing at 3.6% in September according to Eurostat’s flash estimate, after 3.8% in August. This still worrying level of inflation is largely the consequence of both the direct and indirect effects of past surges in energy and food prices at the global level. Moreover, wage growth has been picking up rather strongly in recent quarters, in spite of a weaker growth momentum and at a time when labour productivity growth has decelerated. This resulted in a sharp increase in the year-on-year unit labour cost – to 3.4% – in the second quarter of this year, after several years of more moderate increases in the order of 1-1½%.
The ECB is also highly concerned about shock waves from the global credit crunch creeping up European shores since Monday, when banks in Belgium and Iceland were nationalized, German taxpayers were obliged to foot a €26.9 billion bill in federal guarantees for Hypo Real Estate and the UK nationalized home lender Bradford & Bingley.
Is a Concerted ECB-Fed Action In the Cards?
Trichet said in a CNBC Europe interview after the press conference that the ECB stands ready to act whenever necessary. He evaded a question whether this could mean a concerted action by the ECB and the Federal Reserve, repeating his statement to be ready at all times.
Trichet will attend a weekend meeting of EU leaders in Paris that will deal with the ongoing financial turmoil in Europe. A war of words has already erupted since French president Nicolas Sarkozy proposed a €300 billion bailout fund for failing Eurozone banks. Germany immediately rejected Sarkozy's idea on the grounds that it opposes further bailouts ultimately paid for by the taxpayer. Evidence so far shows that Germany and France will not be able to agree on the Sarkozy initiative.
Why Not Cut the Deposit Rate?
Eurozone credit markets still show no sign of abating tensions. Banks have basically stopped lending to each other, instead preferring to use the ECB's deposit facility that pays a negative real interest rate of 3.25%.
Market participants are increasingly discussing the option that the ECB could cut the deposit rate in order to push banks back into the interbank market. Deposits had mushroomed and passed the €100 billion mark this week, a clear sign that banks do not want to lend to each other because of the unprecedented default risk.
Instead of cutting rates, the ECB has addressed the financial crisis by increasing its short-term lending to banks fearful of lending money to each other, fulfilling its role as lender of last resort.
On Thursday, the ECB again injected cash into the money markets, allotting $50 billion in overnight dollar liquidity at a single rate of 2.75%. Demand outstripped supply, with total bids amounting to $67.215 billion.