Thursday, February 12, 2009

2 cental banks, 2 different paths

Published: February 5, 2009

The European Central Bank<> left its benchmark interest rate unchanged Thursday even as the Bank of England cut its rate to 1 percent in its fifth consecutive monthly reduction.

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Hannelore Foerster/Bloomberg News

"It was a very profound and deep meditation," said Jean-Claude Trichet, president of the European Central Bank, describing the decision to keep the bank's benchmark rate at 2 percent.

The European bank left its rate at 2 percent after four reductions since early October but is expected to cut the rate at its next meeting in March. Inflation started to slow in January, and the economy of the euro region is expected to shrink 2 percent this year, according to the International Monetary Fund<>.

At a news conference, the bank president, Jean-Claude Trichet<>, acknowledged that financial markets were betting on a reduction to 1.5 percent next month. In March, the central bank will publish its new forecasts for economic growth in the euro area, which comprises 16 nations. The predictions are expected to show a marked deterioration since December.

But some analysts argued that the European bank should cut rates more proactively now to offset the squeeze in credit to European companies.

"I am getting more nervous about how the banking side will work out, and what the impact will be on the real economy," said Erik Nielsen, chief Europe economist at Goldman Sachs<> in London.

Unlike the Bank of England, which is gradually moving its key rate toward zero, and the Federal Reserve<>, which has already reduced its rate to about zero, the European bank is still debating internally whether it can afford to go to zero. Some officials argue that cheap credit is what created the current financial crisis<>, and Mr. Trichet hinted at the bank's meeting on Thursday that the subject was still contentious.

"At today's meeting, we exchanged all possible views," Mr. Trichet said. "It was a very profound and deep meditation."

As debates continue, the outlook for Europe's economy is darkening. Retail sales declined more than economists expected in December as consumer confidence dropped. Service and manufacturing industries in the region shrank for an eighth month in January and confidence in the economic outlook fell to a record low. In Germany, manufacturing orders slumped more than expected in December and bankruptcies in Spain's once-buoyant construction industry are accelerating, putting more pressure on lenders that struggle with increasing numbers of bad loans.

In Britain, where the Bank of England cut the lending rate by half a percentage point on Thursday, pressure on Prime Minister Gordon Brown<>'s government is mounting to introduce stimulus measures as monetary policy reaches its limit and workers stage walkouts asking for more job security.

"Unemployment is rising pretty rapidly and that's restraining consumer spending and reinforces the vicious circle of a downturn," said James Knightley, an economist at ING Financial Markets in London. "More stimulus is needed. Credit availability is still very tight."

The government is trying to push banks to resume lending, especially to small and medium-size companies, to support jobs and restore consumer confidence. Just weeks after introducing a loan insurance plan, Mr. Brown conceded that lowering interest rates could have only limited impact and more needed to be done. As unemployment moves toward two million, consumer confidence has continued to slide and inflation has slowed significantly.

To keep Britain from sliding deeper into a recession, the government already gave the central bank power to buy bonds<> and commercial paper<> for as much as £50 billion ($73 billion) and the bank's governor, Mervyn King, said last month that the bank would buy assets within "weeks and not months."

The worsening recession started to take a toll on the popularity of Mr. Brown's Labor Party, whose ratings dropped below that of the opposition party after the government admitted an initial effort to improve lending was inadequate to deal with the crisis.

Hundreds of workers at oil refineries and power plants went on strike this week, saying they feel let down by Mr. Brown and accusing the government of failing to safeguard jobs.

Consumer confidence in Britain fell close to a record low in January as unemployment rose to the highest since January 2000 in December and amid concerns the recession could be worse than that of the early 1980s. Automakers started to abandon night shifts and reduce production and work hours to reduce costs.

Among the options being discussed by the British government to revive the economy is allowing banks to sell their toxic assets to a state-owned bad bank, but some analysts argued that a bad bank alone would cost the government billions of pounds without any guarantee that it would help to resume lending. Another possibility is to bring more banks fully under government control.

The Bank of England said earlier this week that it accepted £287 billion ($409 billion) of collateral as part of its emergency lending measures for banks. It lent £185 billion in Treasury bills against the collateral. The bank is expected to update the markets with its December inflation report on Feb. 11.

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