Unused weapons in a euro slasher

A sharp cut to the eurozone's growth forecast coincided with intensification of Greece's economic depression, but failed to spur serious consideration of negative interest rates.

Europe was in focus overnight. The European Central Bank gave updated forecasts for the economy, Greek unemployment rose again and political tensions emerged in Italy as Silvio Berlusconi’s People of Freedom Party withdrew support from Prime Minister Mario Monti in a move which could prompt an early election.

The market reaction was strong. The euro fell around 1 per cent against the US dollar, the yield on German 10-year government bonds fell to a near record low of 1.30 per cent, while 2-year yields were again negative at -0.05 per cent. In France, 10-year bond yields fell to 1.99 per cent. Reflecting greater risk, Italian 10-year government bond yields rose 13 basis points to 4.58 per cent as investors judged that an early election would jeopardise the already fragile fiscal outlook.

The ECB held interest rates steady at a record low 0.75 per cent, but it painted a picture of ongoing economic misery in its latest assessment of the outlook.

The ECB economic forecasts made for somber reading. Even though 2012 is near an end, the forecast for GDP growth was revised from -0.4 per cent to -0.5 per cent. This is bad enough, but the big downgrade was for 2013, where the ECB has cut its GDP forecast from 0.5 per cent growth to -0.3 per cent. While these forecasts were close to what the market consensus has been factoring in, it is a particularly gloomy outlook for what is the world’s largest economic zone.

The downgrade of the economic outlook from the ECB came at the same time that the latest labour market data for Greece showed a further intensification of the economic depression. In Greece, the unemployment rate rose to a staggering 26 per cent in September, up from 18.9 per cent a year ago and under 8 per cent in 2007. The youth unemployment rate (for people aged 15 to 24), is 56.4 per cent. There are more stories of social unrest, deepening poverty and general misery in Greece as the government implements fiscal austerity measures so that it can qualify for funds to cover its massive level of debt.

ECB President Mario Draghi summed up the economic outlook for the eurozone, saying "weak activity is expected to extend into next year”. That said, Draghi noted – or is it he hoped and wished? – that "later in 2013, economic activity should gradually recover as global demand strengthens and our accommodative monetary-policy stance and significantly improved financial market confidence work their way through to the economy”.

It was somewhat surprising that Draghi said that an interest rate cut was not forcefully considered by the ECB’s policy setting group. Given the revised economic outlook and the ease with which interest rates can be cut, which is with the mere stroke of a pen, Draghi noted it was "much more than you can achieve by a cut in the policy rate.”

While a 25 basis point cut to 0.5 per cent, or even a larger cut to 0.25 per cent, would not be the silver bullet to return the eurozone to economic strength, it seems odd that this simple policy change is not being implemented as soon as possible to give some extra support to the beleaguered economy.

In what would have been a step in the right direction, Draghi noted that consideration was given to setting a negative interest rate on the ECB’s deposit facility. This was seen as a measure to discourage banks from hoarding cash, so that they may start lending to the private sector and in the process, provide support for economic activity.

The ECB, unfortunately, did not take that step, even though it seems to be a no-brainer.

It is hard to see how the eurozone will ever return to a decent pace of economic expansion while obvious policy changes are talked about but not implemented. Fiscal policy is being tightened, the recession continues and monetary policy changes are being delivered in a cumbersome way. And despite today’s drop, the euro is still too strong to spark an export pick-up.

The downgraded economic view of the ECB may yet to be too optimistic. Even Draghi acknowledged that risks to the latest downgraded forecasts were skewed lower. It looks like a tough year or two ahead for the eurozone and those who depend on it for export markets, especially China.

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