Friday, December 5, 2008

Trichet Under Pressure to Outline Plan for Deflation (Update1)

By Simon Kennedy

Dec. 5 (Bloomberg) -- European Central Bank President Jean- Claude Trichet is under pressure to outline a plan to revive the euro region’s economy should he be “trapped” into pushing interest rates closer to zero.

Even as Trichet delivers the largest round of rate cuts in the ECB’s history, he hasn’t spelled out a specific approach should conventional tools fail to head off deflation. While he yesterday acknowledged for the first time that unorthodox measures are an option, economists say the lack of detail is a concern.

“The ECB should lean against the wind as deflation talk inevitably becomes widespread,” said Marco Annunziata, chief economist at Unicredit MIB in London. “This would be best achieved by taking the deflation risk seriously, and outlining a contingency plan against it.”

The absence of a public strategy leaves Trichet lagging Federal Reserve Chairman Ben S. Bernanke, who said Dec. 1 he may turn to alternative policies such as buying Treasuries after cutting the benchmark rate to 1 percent. Bank of England Governor Mervyn King conceded last month that he may have to coordinate policies with the government if U.K. rates fall to zero.

Trichet instead stresses the need to hold on to as much ammunition as possible before discussing other approaches. At 2.5 percent, the ECB’s main rate is still the highest in the Group of Seven nations even after yesterday’s 75 basis point cut.

Deflation Dismissed

“We have to beware of being trapped at nominal levels that would be much too low,” Trichet told reporters. He dismissed the likelihood of deflation and said only that buying assets was a possibility for the ECB, without elaborating further.

“We are looking at the situation as cautiously and attentively as possible,” Trichet said. “At this stage I have no further indications to give.”

That’s a concern to economists at Royal Bank of Scotland Group Plc and Goldman Sachs Group Inc. who fret that without a road map for recovery, banks may continue to limit loans to consumers and companies. Seventeen months into the financial crisis, the interbank lending market remains strained, restricting the flow of credit through the economy and stifling growth.

‘Transparency and Predictability’

“Transparency and predictability are needed from the ECB,” said Erik Nielsen, chief European economist at Goldman Sachs in London. “We need to know as much as possible about what could be done even if it’s not likely.”

One step the ECB could consider is buying commercial paper and then government debt, said Royal Bank of Scotland economist Jacques Cailloux. It could even begin buying private assets before rates approach zero, given that monetary policy is less effective when the financial system is frozen, he said.

Bernanke has already started purchasing corporate paper and said this week that the Fed could also “buy longer-term Treasury or agency securities on the open market in substantial quantities.” Fed policy makers may decide at their next meeting Dec. 15-16 on the details of such a shift, which might resemble the “quantitative easing” strategy the Bank of Japan adopted in 2001-2006 when its key rate neared zero.

New Approach

“It’s hugely important that the ECB clarifies what it can and cannot do if the crisis continues,” said Cailloux. “Doing so would send a big confidence signal to markets that the ECB is willing to use unconventional methods to help the economy.”

The purpose of buying securities would be to reduce long- term rates, making it less attractive to hoard cash and more likely that companies and consumers start to stimulate the economy by spending, said Axel Botte, a fund manager at Axa Investment Managers in Paris, which has about $800 billion in assets under management.

“When rates near zero you need to look to alternative methods to get people to spend,” he said.

Trichet and his colleagues still have more time than their counterparts in the U.S., where deflation could emerge in 2010 and interest rates are already on the cusp of zero, said Dario Perkins, an economist at ABN Amro Holding NV in London.

Deflation, or a prolonged decline in prices, is less likely in the euro region because labor market regulations and a lack of competition mean wages and prices are “sticky” and so slower to retreat than those in the U.S., he said.

One reason for not mapping out what more it could do is that the bank’s 21-member Governing Council is split, said Stuart Thomson, who helps oversee $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland.

Trichet declined to say whether yesterday’s decision to cut rates by three quarters of a percentage point had been unanimous and council member Yves Mersch said quarter-point cuts are more likely in future.

“I’d like to see the ECB take more leadership but they continue to be a lagging and reactive central bank,” said Thomson.

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