Bickering ECB May Cut Benchmark Rate to 1%, Lengthen Bank Loans

By Gabi Thesing


May 7 (Bloomberg) -- The European Central Bank will probably cut its key interest rate to a new record low today and offer banks longer-term loans to stem the region’s worst recession since World War II.

ECB officials meeting in Frankfurt will lower the benchmark rate by a quarter point to 1 percent, according to all 53 economists in a Bloomberg News survey. The central bank, led by President Jean-Claude Trichet, may keep the rate there until the third quarter of 2010, a separate survey shows.

“They are pretty much done with rates,” said Ken Wattret, chief euro-area economist at BNP Paribas in London. “The question is now what happens beyond that. With the economy still in the doldrums and deflation a real risk, Trichet will have to keep the door open to do whatever is necessary to fight those risks.”

The difficulty for Trichet is that his 22-member Governing Council is split over how best to proceed. Germany’s Axel Weber wants the ECB to signal that 1 percent is the floor for the key rate and has argued against buying government or corporate debt to boost the economy. Others such as Athanasios Orphanides of Cyprus say asset purchases and deeper rate cuts may be needed.

“The continuing divisions and bickering risk delaying the appropriate policy response,” said James Nixon, an economist at Societe Generale SA in London. “What they announce today will be woefully inadequate given the challenges facing the economy.”

Weber’s Prescription

The ECB announces its decision at 1:45 p.m. in Frankfurt and Trichet holds a press conference 45 minutes later. Separately, the Bank of England will probably hold its key rate at 0.5 percent. That decision is due at noon London time.

The Bank of England, U.S. Federal Reserve and Bank of Japan are already buying bonds, effectively printing money to reflate their economies in a policy known as quantitative easing.

With recent economic reports in Europe suggesting the worst of the recession is over, Trichet may find common ground around the less aggressive approach put forward by Weber.

Arguing that asset purchases are not required, he is instead pushing for the ECB to extend the maturities on its loans to banks to ease tensions in money markets.

The measure may force colleagues to sign up to his second request -- a signal from the ECB that interest rates won’t drop any further. That’s because banks would be reluctant to take up long-term loans if they thought credit could get cheaper.

Winning the War?

Council member Yves Mersch and Executive Board members Juergen Stark and Lorenzo Bini Smaghi have signalled support for Weber’s view. They’re squaring off against council members who want to preserve the option of further action such as Orphanides, Nout Wellink and George Provopoulos, opening perhaps the biggest split among ECB policy makers in the bank’s 10-year history.

“Weber is a heavyweight and his views always carry a lot of sway,” said Aurelio Maccario, chief euro-area economist at UniCredit Group in Milan. “It looks like he will win this battle but maybe not the war. There are a number of other influential voices on the council and the ECB could still launch an asset-purchase program down the line if things get worse.”

The 16-nation economy will shrink 4.2 percent this year, according to the International Monetary Fund, more than the projected 2.8 percent contraction in the U.S. and 4.1 percent slump in the U.K.

While the pace of decline in Europe’s service and manufacturing industries is easing, lending to companies and consumers dropped for a second straight month in March and a European Commission survey shows households expect prices to fall over the next 12 months.

Deflation Threat

Inflation was 0.6 percent in April. The ECB, which aims to keep the rate just below 2 percent, says it may dip below zero this summer.

“If inflation threatens to remain significantly below 2 percent for a considerable period of time, then additional policy easing could be warranted” after May, Orphanides, a former Fed adviser, said in an April 14 interview.

Even though almost three quarters of company financing in the euro area comes from banks, buying corporate debt may be helpful because “all asset markets are interconnected,” Orphanides said.

“The euro area is clearly experiencing a deep recession,” said David Mackie, an economist at JPMorgan in London. “It is hard to see how the region can avoid something that looks a lot like deflation. The ECB should be putting in place the most accommodative policy stance possible, and leaving it in place for an extended period of time.”