18 January 2001, 10:35  OUTLOOK: ECB to leave rates steady today; rate cut expectations overdone

PARIS (AFX) - The European Central Bank will leave leading interest rates unchanged at today's governing council meeting, economists said. Market expectations of an early rate cut have been greatly overdone and it is likely to be some time before the ECB contemplates an easing move, they said.
Euribor futures prices point to market expectations that the ECB will lower the minimum bid rate on its main refinancing rate by 0.75 points by the summer, from the current 4.75 pct level.
Such rate cut expectations have been fuelled by the U.S. Federal Reserve's Jan 3 easing move, the euro's recovery, oil price declines and a moderation in M3 growth.
But economists said markets are misreading the ECB's intentions.
"There will be no change. Everything has been blown out of proportion at the moment," said Ulla Kochwasser of Industrial Bank of Japan, who expects rates to be left unchanged throughout 2001. "Market expectations of a euro area cut as early as this quarter appear premature," said Jean-Francois Mercier and Carmen Nuzzo of Schroder Salomon Smith Barney.
Of 37 economists polled last week by AFX News and Agence France-Presse, all said they expect the minimum bid rate to be left at 4.75 pct on Thursday, and only seven predicted an easing move before the end of the first quarter.
The ECB is clearly not overly worried about the impact of the U.S. economic slowdown on euro zone growth and therefore it is wrong to assume that it will simply follow the Fed lower, economists said. In its January monthly bulletin last week, the ECB spoke of "a picture of continuing robust, albeit slightly lower, growth rates".
And chief economist Otmar Issing said the euro zone economy will remain at a high level of growth, with U.S. interest rate changes not immediately affecting the ECB's interest rate policy.
"As long as the ECB remains convinced that the slowdown in the U.S. will have little impact on the euro area economy, the upward risks to prices will probably continue to dominate over the downward risks," said Michael Schubert of Commerzbank.
Moreover, the ECB will not want to undermine the euro's recent recovery against the dollar, and will want to see further euro gains to help boost public confidence in the currency ahead of the Jan 2002 introduction of euro notes and coins. Such gains are only likely if the gap between U.S. and euro zone interest rates narrows further, economists said.
"It may well prove difficult for the currency to strengthen if the ECB is inclined to follow the Fed's lead on interest rates," said Schubert.
"The euro has certainly appreciated significantly since the end of November, but the ECB wants to consolidate this gain, particularly ahead of the introduction of euro notes and coins," said Emmanuel Ferry of Exane.
The Fed's Jan 3 cut reduced the gap between its Fed funds target and the ECB minimum bid rate to 125 basis points, but this differential is likely to narrow further, economists said.
A further cut in the Fed funds rate, currently at 6 pct, is widely expected at the Jan 30-31 Federal Open Market Committee meeting, and the ECB will only consider lowering its own rates by a limited amount well after any further Fed easing, economists said.
"Once the Fed has reduced to a level of 5.5 pct, which would be expected by next summer...then the ECB will be able to lower its refi rate by 25 basis points without compromising the value of the euro," said Marc Touati of Natexis Banques Populaires.
Even CSFB, which expects the Fed funds rate to be cut by a further 100 basis points to 5 pct by mid-year, said it only expects the ECB to trim 50 basis points from the minimum bid rate in two steps starting in the second quarter.
The ECB does not need to be in any rush to ease credit because its current rates are still relatively accommodative, economists said.
"Even after the recent Fed 50 basis point cut, monetary conditions are relatively tight in the U.S., while remaining accommodative in the euro area," said Mercier and Nuzzo.
Belgian National Bank governor Guy Quaden this week suggested that this also remains the ECB's view, noting that ECB rates "cannot currently be regarded as damaging economic growth".
Some observers detected a shift in the ECB's message in the January monthly bulletin, in which it highlighted the prospects for lower inflation in the months ahead.
But economists said any shift was one towards neutral from the more hawkish message of December, rather than any signalling of early rate cuts.
"We reckon the ECB signalled another small step in the direction of a balanced assessment -- there was probably still a tightening bias in December -- but no intention to ease," said Lorenzo Codogno of Bank of America.
In the bulletin, the ECB insisted that there are "still elements of upward risks to price stability which warrant close monitoring", focusing particularly on the possibility of inflationary wage rises and the need for tax cuts to be matched by reductions in government spending.
"The ECB thinks that there are enough price risks to the upside not to cut rates for the moment, primarily from the wage side. There is also the boost to come from fiscal reforms in Europe," said Kelly Tonkin of Lehman Brothers.
Ferry of Exane said the inflationary effects of tax cuts in particular will deter the ECB from lowering rates.
"The policy mix is expansionist. Governments have introduced massive tax cut programmes, often in a pre-electoral context. The ECB will feel obliged to compensate for this pro-cyclical trend by a more restrictive posture on the monetary side," he said.
Moreover, although inflation is expected to fall, it is currently well above the ECB's 2.0 pct price stability ceiling, reaching 2.9 pct in November. Cutting rates with inflation above the central bank's own tolerance threshold would send out the wrong signals, economists said.
Most economists -- 28 of the 37 polled by AFX and AFP -- do expect the ECB to cut rates at some stage, but the bulk of these do not expect the easing move to come until the second quarter and some only see a rate cut later in the year.
"The ECB will not start to ease until the third quarter, or even the fourth quarter. Our central scenario is for a first move of 25 basis points only in September. By that time the Fed will probably have lowered its target rate by at least 100 basis points," said Ferry. And ECB rate cuts are expected to be limited in scale.
"There is no reason to increase rates, but nor is there really any reason to cut aggressively. With the U.S. economy slowing, the next move could be a cut in the second quarter, particularly if the euro continues to appreciate, but there will not be much more movement in rates after that," said Philippe Weber of CPR.
A minority of economists do see scope for aggressive rate cuts. Eckhard Schulte of Dresdner Kleinwort Benson predicts that the refi rate will be cut to 3.75 pct by the summer, noting: "If the Fed cuts rates once more and the world economy stalls then the pressure on the ECB will be huge."
But there is also a sizeable minority which expects no cut in rates at all. Eight of the 37 economists in the AFX/AFP poll said rates will be left unchanged throughout 2001 and one forecast that rates will actually be raised towards the end of the year.
"We would not be surprised by some softness in the ECB's statements during the second quarter, but no actual cut is on the cards yet," said Sirpa Wallius of Merita Bank.

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