Central Banks Respond to Global Weakening

Posted by Adolfo Laurenti on July 5, 2012

Today the European Central Bank (ECB) cut interest rates by 0.25%, to a new historical low of 0.75% for its “refi rate” (the ECB policy target rate.) Furthermore, two other central banks took action: the Bank of England accelerated its quantitative easing program by adding 50 billion pounds ($78 billion) to  its bond-purchasing program. The People’s Bank of China announced the reduction of about a quarter percentage point for its one-year lending rate, now 6.0%, and for its one-year deposit rate, now 3.0%. This is China’s second move to cut rates within a month.

There are two immediate implications, one for the global economy and one for the euro area:

First, it is apparent that the recession in the euro area, disappointing data from the U.S. and a deceleration of growth in China have heightened policy makers’ concerns. The somewhat coordinated interventions we saw today are encouraging, because they show how central banks are willing to work together to counter a slowdown that, despite its regional roots, is genuinely global in its consequences.

In the case of Europe, the actions by the ECB also suggest that inflation hawks are coming to terms with reality. Hardliners had promised that the recession triggered by austerity would be “short and shallow;” it is now apparent that it will be long and deep instead. Our forecast now includes a contraction in the euro area for the year 2012, with severe downturns in many countries (we see Italy -2.3%, Spain -1.8%). Even the growth engine of the region, Germany, we expect to expand by a meager 0.6% this year, suffering from weakening in European partners’ economies. It is likely that recent, abysmal forecasts were instrumental in persuading even the notoriously hawkish German representative within the ECB to support the loosening of  monetary policy.

Bottom Line: Economies around the world are weakening. We hold the realistic view that little upside risk may occur for the rest of the year. At the very best, we face a summer of muddling through, under the risk that Europe may continue along its downward spiral. The silver lining is that central banks are stepping in, regardless of how little ammunition may be left in their arsenals. The ECB is the institution that can do the most; today, it sent a clear signal that it’s ready to do its part. Of course, the euro area cannot be rescued by monetary policy alone. The ECB can accommodate, but not replace, the work that political leaders are supposed and expected to do on structural reform and fiscal rebalancing. Clearly, an awful lot more remains to be done on that front.

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