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ECB Strikes Hawkish Tone on Interest Rates as U.S. Fed Plans Further Cuts

By , Money Morning •

By Jason Simpkins

Associate Editor
Money Morning

While the U.S. Federal Reserve is expected to cut its benchmark Federal Funds target rate to a record-low 0.5% at its policymaking Federal Open Market Committee meeting tomorrow (Tuesday), the European Central Bank (ECB) is signaling a reluctance to drop its key rate below 2.0%.

Since the Euro-region slipped into a recession in October, the ECB has cut its main interest rate by 175 basis points to 2.5%. However, the bank's policymakers, led by ECB President Jean-Claude Trichet, are now sounding calls for more fiscal discipline.

Investors are betting that the ECB will be forced to shave another 50 basis points off its benchmark rate in January, but ECB council member Axel Weber warned last week that the bank "would like to avoid" taking it below that level.

"We should be cautious when our rates approach territory we haven't explored before," Weber told Bloomberg News. "Our lowest level so far was 2.0%."

ECB President Trichet told The Financial Times today (Monday) that there was "a degree of excessive pessimism" when the bursting of the dot-com bubble drove central banks to slash benchmark borrowing costs. Many analysts believe those excessively low lending rates fueled the asset bubbles of the past decade, including the massive run-up in real estate prices whose subsequent collapse helped trigger the current global downturn.

Trichet added that policymakers had a duty "to eliminate as completely as possible all the inbuilt elements in global finance that are amplifying booms and busts."

ECB Executive Board member Juergen Stark said Dec. 10 that any room left for further rate reductions is "very limited, potentially allowing for small steps only."

Of course, there are some analysts who believe the recent rhetoric coming from the ECB is just that.

"They will be forced to go to 1.0% or lower by June," Juergen Michels, chief Euro-region economist at Citigroup Inc. (C) in London told Bloomberg. "The rhetoric at the moment is to justify their forecasts, which are too optimistic."

The ECB forecasts the greater European economy will contract by 0.5% in 2009, before expanding by about 1.0% in 2010.

If the ECB's estimates are too generous, the European central bank could again be forced to backtrack on its policy mandates. The ECB actually raised its benchmark rate to 4.25% in July, with policymakers expressing concern that "price and wage-setting behavior could add to inflationary pressures."

The bank reversed course just four months later in October, cutting its rate by half a point on Oct. 8.

"The ECB should refrain from considering any pause in the easing cycle to avoid falling again behind the curve," Marco Valli, an economist at UniCredit SpA in Milan, told Bloomberg.

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