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Rate cuts likely ahead for European Central Bank

Section: Daily Dispatches

Euro Bank's Hawks Take a Pounding

By Ambrose Evans-Pritchard
The Telegraph, London
Friday, August 8, 2008

Collapsing growth in Germany, Italy, and Spain has forced the European Central Bank to abandon its hawkish policy stance, preparing the way for likely rate cuts in coming months.

Jean-Claude Trichet, the ECB's president, said yesterday that the picture had darkened over recent months and growth was now "particularly weak" across the eurozone. "We knew that there were downside risks, and those risks are materialising," he said after a meeting by the governing council that left rates on hold at 4.25 percent.

The comments caused the euro to plummet by almost two cents against the dollar to $1.5310 yesterday. Traders scrambled to unwind bets on future rate rises.

"The ECB has capitulated on the economic outlook," said Julian Callow, Europe economist at Barclays Capital.

"They have cut out all reference to 'moderate ongoing growth' and no longer seem sure that the economy will recover even in the fourth quarter. I detect meaningful concern," he said.

While Mr Trichet issued the usual warnings about inflation -- now at a eurozone record of 4.1 percent -- these were largely ignored by market players convinced that the tightening cycle is at last over. There is growing speculation that the seven-year surge in the euro against all major currencies may also have peaked.

Hans Redeker, currency chief at BNP Paribas, said the ECB had blundered by raising rates a quarter point into the teeth of the storm last month, misjudging the severity of the credit crunch as banks cut overdraft lines to companies in need. "The July rate rise looks like a policy mistake in need of being urgently reversed," he said.

Data across the region has been dire over recent weeks. The great shock has been the precipitous downturn in Germany, viewed as the export locomotive for the whole currency bloc.

Officials in Berlin say Germany's economy contracted by 1pc in the second quarter. Industrial orders have fallen for seven months in a row, led by a collapse in orders for machine tools and equipment from Asia.

The whole Pacific region is now slowing hard. Japan's Cabinet Office declared this week that the country was almost certainly in recession after output fell by 2.3 percent in the second quarter.

New Zealand has declared a recession. Hong Kong and Singapore have both issued growth warnings. Lehman Bros says there is evidence of a "generalised slowdown" in China, with a risk that tumbling property and equity prices could combine with sharply slowing exports. A third of the clothing factories in Guangdong have closed this year.

Jim O'Neill, chief economist at Goldman Sachs, said the slide in Germany had knocked away the eurozone's key prop. "There's not much left once you take out Germany's staggering export growth. Each time there's a global shock, European policy makers say that they are relatively immune, and each time that turns out not be the case," he said

The picture is now uniformly grim across Europe. Ireland is in recession. "Italy's economy is comatose," said Prof Nouriel Roubini, from New York University. House prices are falling in France and consumer confidence is at a 21-year low.

Spain's manufacturing output fell 9.5 percent in June, confirming fears that the crisis is spreading rapidly from the collapse in the construction sector (18 percent of GDP) to the rest of the economy.

The Spanish credit association Adicae said yesterday that the issuance of new mortgages had dropped by 40pc in June. The number of households with mortgage "troubles" has reached four million.

Unemployment is expected to reach 2.7 million or 12.5 percent by the end of the year. "The number of people in difficulty has risen intensely," said the group.

Neil Mellor, a currency strategist at the Bank of New York Mellon, said it was still too early to assume that the ECB had finished tightening. "The data has been dreadful, but the ECB has surprised us before. They are monetarists after all," he said. Mr Trichet fears the start of a 1970s wage spiral as the effects of the oil and food spike feed into inflation expectations. He said it was "absolutely essential" to avoid second-round contagion feeding through the wage system.

Lufthansa staff have just secured a pay deal of 5.1 percent, setting the stage for the autumn pay rounds with car workers giant IG Metall. Some degree of pay catch-up in Germany is expected after the ferocious squeeze of recent years. The problem is more serious in Spain and Belgium -- and to a lesser extent Italy and France -- which still index pay settlements to inflation. The result is to lock these countries into sliding labour competitiveness, and widen the rift between EMU states.

Europe's notoriously "sticky wages" prevents crumbling growth from bringing down inflation rapidly as in Anglo-Saxon states, and helps explain why the ECB is less willing to "look through" the current oil price surge than the US Federal Reserve.

"This indexation is a serious danger," said Jean-Michel Six, Europe economist at Standard & Poor's. "It makes it much harder for the ECB to steer monetary policy in the single currency. It should be stopped altogether."

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