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Ahead of the ECB

Written by A Forex View From Afar on Wednesday, December 03, 2008

The market awaits the ECB’s interest rate decision tomorrow expecting the bank to cut another 50 basis points, down to 2.75%. The calls for a rate cut have received strong support lately, as the economy is heading towards a full-blown recession and the CPI read is starting to show deflation, rather than any price increase.

Last week, the Euro-area Flash CPI report showed that inflation dropped 1.1% in November to 2.1%, the biggest one month drop on record.
Most analysts say that with this huge drop in the inflation numbers, the ECB has a clear path to ease its monetary policy in the coming meetings. The Euro-area overnight rate, called Eonia, reached 2.91% yesterday, much lower than the ECB’s targeted rate of 3.25%. The difference between the targeted and the overnight rate shows that inter-banking markets now expects at least a 25 basis point rate cut. Some analysts had even increased their forecast for the next meeting held on December 4th, to a 75 basis point rate cut.

However, analyzing the CPI by its components, the biggest increases came from the energy sector. Lately, oil touched a 3-year low, declining close to 60% from the top reached earlier this year. Because of the way the CPI is calculated, rather to absorb over a long term price shocks, the CPI read will continue to decline in the coming months, well under the ECB’s target of 2% over the medium term, giving much more room for the ECB for rate cuts.

The question that comes now is how much exactly has the market “priced in” for any further rate cuts? The euro closed today around the same value it closed on November 6th, after the central bank had slashed the interest rate by 50 basis points. In the last few weeks the euro has managed to find a solid base, but if things do not go as planned tomorrow, we might see a test of recent support areas.

Mr. Trichet’s speech that closely follows the interest rate decision might give some additional clues about the next move the ECB is planning. Until now, the ECB has communicated very clearly with the market, especially when a change in the interest rate direction was prepared. Clear statements are an essential tool for any central bank trying to implement its policy, so a very clear message is expected tomorrow.

Furthermore, traders might find some additional clues about the future interest rate in the ECB’s staff projections, which will be updated tomorrow. The latest projections were released in September, and back then the GDP was set to grow between 1.1% and 1.7% in 2008 and between 0.6% and 1.8% in 2009. It’s very likely these numbers will be downgraded much lower. Also in September, the CPI was projected to grow between 3.4% and 3.6% in 2008 and between 2.3% and 2.9% in 2009. Most say the CPI read will be revised significantly lower.

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