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ECB Needs to Reverse Rate Increases to Prevent Recession, Economists Say

The European Central Bank should reverse this year’s rate increases to prevent the euro-area economy from slipping back into recession, members of the so- called shadow ECB council said.

A contraction in European manufacturing and plunging business and consumer confidence suggest the sharp slowdown in economic growth in the second quarter may continue in the third, they said. The ECB shadow council is a group of 15 economists and portfolio managers who watch economic developments and monetary policy in the euro region and issue recommendations each month. The Frankfurt-based ECB has raised its benchmark rate twice in 2011, taking it to 1.5 percent from 1 percent.

“My recommendation is for the ECB to lower the policy rate by 50 basis points as insurance to lower the risk of outright recession re-emerging,” said Julian Callow, chief European economist at Barclays Capital in London. “The economic deterioration has become sufficiently rapid and alarming to warrant an immediate unwinding of the ECB’s rate hikes.”

The ECB has reversed direction before. In 2008 it raised rates in July before being forced to cut them to a record low after the collapse of Lehman Brothers Holdings Inc. triggered a worldwide recession. Three years later, the risk of a renewed global slump has risen as Europe struggles to contain a debt crisis and the U.S. economy is restrained by unemployment above 9 percent.

Cuts Forecast

The euro extended its decline this morning, taking its drop against the dollar this week to 2 percent. It traded at $1.4218 at 9:27 a.m. in Frankfurt.

While ECB shadow council members say what they think the central bank should do -- rather than what they expect it to do -- some economists are now forecasting rate cuts later in the year.

“The chance of further interest-rate hikes has evaporated and a reversal of earlier increases now seems more likely,” said Jennifer McKeown, senior European economist at Capital Economics Ltd, which isn’t represented on the shadow council. “We have penciled in 25 basis-point interest rate cuts in December and March.”

The chance of a recession in the euro zone has risen to 50 percent, Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., said in an interview yesterday. That’ll force the ECB to lower its benchmark rate, he added.

No Fiscal Stimulus

“The ECB needs to consider the possibility of reversing the two interest-rate increases implemented earlier this year,” said shadow council member Marie Diron, senior economist at Oxford Economics in London. “Should the growth outlook worsen, the ECB may need to lower interest rates below 1 percent given the impossibility of fiscal stimulus.”

Growth in the 17-nation euro region slowed to 0.2 percent in the second quarter from 0.8 percent in the first as governments cut spending to rein in budget deficits, damping demand. Germany’s economy, the region’s largest, almost ground to a halt. Euro-area manufacturing contracted for the first time in two years in August, a survey of purchasing managers by Markit Economics showed yesterday.

Elga Bartsch, chief European economist at Morgan Stanley in London and a member of the ECB shadow council, said she’s reduced her growth forecast for the euro area next year to just 0.5 percent to reflect the “marked deceleration in manufacturing activity.”

Abating Inflation

“Inflation pressures should likely abate very quickly in the coming months,” Bartsch said. “Against this backdrop, I would advocate that the ECB contemplates a reversal in its monetary policy decisions and starts to cut its main refinancing rate.”

Inflation, which the ECB aims to keep below 2 percent, held at 2.5 percent in August. The global slowdown is damping demand for fuel, driving down oil prices that have been a key source of inflation. Crude has dropped to $88 a barrel from $114 per barrel in April.

ECB President Jean-Claude Trichet signaled this week the bank may revise its assessment that inflation risks are on the upside, paving the way for a halt in its policy tightening.

Marco Annunziata, chief economist at General Electric Co. in London, said there is little doubt that downside risks to the growth outlook have increased in the euro area and in the U.S.

‘Watch the Data’

“However, I think there is scant evidence that the euro zone is at risk of a double-dip recession,” said Annunziata, a member of the shadow council. “The second-quarter slowdown came after very robust growth in the first quarter. The right strategy at this stage, in my view, would be to hold rates where they are, watch the data and focus on financial stability, which is the main threat.”

An ECB interest-rate cut wouldn’t necessarily improve the current economic situation in the euro area, Martin Feldstein, a professor of economics at Harvard University, said in an interview with Bloomberg Television today.

Some $5.3 trillion has been wiped off equity markets since July 21, after a summit of European leaders failed to prevent the region’s debt crisis from spreading to Italy and Spain and the U.S. saw its credit rating downgraded for the first time.

ECB policy makers next convene on Sept. 8 to decide on interest rates.

“Earlier this year I voted in favor of higher interest rates, arguing they were necessary to anchor inflation expectations,” said Andrew Bosomworth, executive vice-president and senior portfolio manager at PIMCO in Munich and a member of the ECB shadow council. “Developments over the last two months have changed my outlook.”

To contact the reporters on this story: Jana Randow in Frankfurt at jrandow@bloomberg.net; Jeffrey Black in Frankfurt at jblack25@bloomberg.net

To contact the editor responsible for this story: Matthew Brockett at mbrockett1@bloomberg.net

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