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Wednesday, May 01, 2013 11:59 AM

Expect ECB to Cut Rates on Friday; Even a "Shock-and-Awe" Cut Won't Help One Bit

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Eurozone inflation collapsed to 1.2% in the latest report, from an expected print of 1.6%. Given the ECB has an inflation target of 2%, rate cut calls range all the way from a cut of 25 basis points to a cut of 75 basis points.

With the current rate at .75%, a 75 basis point to 0% is very unlikely. A cut of 25 or 50 basis points is almost certain but even 50 basis points won't do much good.

Steen Jakobsen, chief economist at Saxo Bank writes via email:

Calls for cut in ECB rate by 25 bps from 75 bps to 50 bps. We see 25 bps


Inflation have dropped to +1.2% against at target of +/- 2.0%
Unemployment rate now at 12.1% in Europe (A record high)
Survey data again going south
Data been weaker into the meeting
European GDP is looking like -1.5 / 2.0% right now without ‘some miracle’ or stimulus help.


Monetary policy is impotent at zero bound. 25 bps plus or minus will not change the banks appetite for risk – ECB latest lending report says that in excess of 30% of banks see less appetite for lending to SMEs [Small to Medium Enterprises] vis-à-vis last quarter. Only exception is Germany where the number is +6%

ECB needs to create better “transmission” – however local regulators prevent this as Spain has a minimum mortgage rate of 325 bps is in place and the Netherlands a 300 bps minimum. Moreover,  banks are under capital constraint due to incoming increase demand from BIS III.

A TARP-like institution backed by tax receipt is very unlikely as Germany again shot down any belief in banking union only yesterday.
Investors Fooling Themselves

Echoing the opinion of Steen, please consider Investors may be fooling themselves about an ECB rate cut
High hopes ride on the European Central Bank, which is set to make its latest monetary policy announcement on Thursday. Despite the fact that poor economic data continues to flow out of the euro zone, investors seem convinced that the euro area is a fleeting concern, and certain that the ECB will cut rates from their current level of 0.75% in order to relax credit.

Despite the likelihood of a rate cut, the euro zone is still mired in a sovereign debt and banking crisis, with a recession that isn’t likely to go away so fast. We’ve already argued that even if the ECB slashes its target interest rate, the effect is unlikely to trickle down into the real economy, and particularly to small- and medium-sized enterprises (SMEs).
The options

Deutsche Bank wraps up all the options it thinks the ECB has (and the likelihood of each happening) in this handy chart:

Importantly, banks are still scared to lend to one another, so they’re paying a premium to fund themselves. While interest rates have fallen across the board because of earlier ECB actions, borrowing rates for SMEs and individuals have not fallen much in the last year.
Shock and Awe?

Consensus is for a 25 basis point cut.

I would not at all be surprised by a "shock-and-awe" announcement of 50 basis points. However, cuts of any size will not help because the problems in the eurozone are structural:

Structural Issues 

  • Banks are undercapitalized
  • Interest rate differentials although way lower are still high
  • Target II imbalances are high
  • Austerity via tax hikes is an absolute killer
  • Work rules in southern Europe are badly in need of an overhaul
  • The Euro itself is fundamentally flawed 

Anyone who thinks that even a 75 basis point cut would solve those issues is not thinking clearly.

Mike "Mish" Shedlock

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