Will the ECB ease further?

The next meeting of the European Central Bank (ECB) to discuss monetary policy is scheduled for Thursday 8 December with an interest rates decision due at 12:45 GMT.  This month the market is pricing in an interest rate cut as the eurozone debt crisis deteriorates.

This week’s ECB policy meeting comes a day before Friday’s crucial EU summit where European leaders are expected to agree on a comprehensive plan to tackle the eurozone debt crisis. Investors remain optimistic that a concrete plan will be reached towards fiscal unity within the eurozone which could calm the markets.

Risk sentiment in the market remains fragile

The economic situation in the eurozone appears to be worsening. Risk sentiment in the market failed to stabilise even after German Chancellor Angela Merkel and French President Nicolas Sarkozy announced that they had reached an agreement about a set of fiscal rules for the eurozone. During the last few months the eurozone economy has been battling with an escalating debt crisis while countries on the periphery have been flirting with the risk of default.

Rating agency Standard & Poor’s surprised the markets on Monday when it put fifteen eurozone countries on a negative credit watch, including the triple-A countries Germany and France. The agency reasoned that the tight credit conditions and disagreements among European policymakers on how to tackle the eurozone debt crisis led to this negative credit watch announcement.

Deflation pressures rise

The ECB appears concerned about a further decline in inflation, which may lead to more interest rate cuts.  The eurozone interest rates are currently 1.25% and the ECB has never cut rates below the 1%, not even after the collapse of Lehman Brothers. ECB President Mario Draghi said last week that the central bank’s mandate is to maintain price stability “in both directions”. In other words, the ECB is concerned about inflationary risks as well as deflationary. Data revealed that annual Consumer Price Index held at 3% in October, for the second month above the ECB’s target of just below 2% but expectations suggest that the rate could slow down sharply over the first half of 2012. The forecast for a fall in inflation reflects the struggling eurozone economy may have room for the central bank to cut rates and help boost growth.

The scenarios – will Draghi ease further?

As the next interest rate meeting is approaching, there is speculation that the central bank will act to boost the economy from falling further by keeping liquidity flowing. A rate cut may stimulate growth as it would make it cheaper for companies and people to borrow, spend and grow. A scenario is that the central bank will announce a 25 basis points interest rate cut to 1%, which may already be priced in market expectations, and a muted reaction is expected. Another scenario is a 50 basis points cut in the benchmark interest rate which may surprise investors and initially cause a fall in the price of the euro. This may surprise investors and put increased pressure on the euro causing it to seek new lows. In the scenario where no interest rate cut is announced, the single currency may initially drop but later it is likely to be supported on hopes the eurozone economy has escaped recession.

ECB’s role

Investors’ real focus will be on the press conference by the ECB President Mario Draghi where signals for further interest rate cuts will be closely watched. What is also important to see is whether Draghi will comment on the ECB’s role in the eurozone debt crisis. Investors are waiting to see if the ECB is prepared to act and guarantee to be the lender of last resort for the troubled countries of the euro area. Whether the ECB will play a bigger and more explicit role in stabilising the European bond markets will be defined by the EU Summit this Friday.

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