Ecb Cuts, Then Shuffles To The Sideline

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TD Economics Commentary January 15, 2009

ECB CUTS, THEN SHUFFLES TO THE SIDELINE The European Central Bank cut the main refinancing rate for the fourth month in a row, bringing the level to 2.00%. This was in line with market expectations, and, while we believed there was a large chance for the ECB to cut less than what they did, the disappointment was delivered during the post-decision press conference instead. There, President Trichet reiterated the Governing Council’s expectation that the level of inflation will be in line with price stability over the medium-term. However, they now see the risks to that expectation to be “broadly balanced,” rather than just “more balanced” as they did in December. Moreover, President Trichet signaled that with the February meeting coming in just three weeks, there is likely to be no meaningful change in the Governing Council’s sentiment until March at the earliest. While we believe the ECB will ultimately need to lower rates 5075 basis points from here, this will likely not come until the April to June period, as the evidence mounts for the ECB that the economic weakness in the Eurozone will linger into the latter half of the year. In making its decision, President Trichet made it clear that the decision today was made not only on the basis of existing weakness, but the expectation that significant economic weakness will persist in the “coming quarters.” Moreover, he cautioned markets that near-term sharp deceleration in inflation is relatively insignificant from a monetary policy perspective. Instead, markets should focus on the fact that Eurozone inflation may see a sharp rebound in the latter half of the year. It is developments in this factor that will drive ECB decisions in the coming months. Our expectation is for an ongoing contraction in the Eurozone economy in the first half 2008, a sluggish acceleration late in the year, and oil prices troughing near $30 by the middle of this year. We believe this profile will give the

TD Economics Commentary

EUROZONE CONSUMER PRICE FORECASTS 5

Y/Y %

5

Actual (black) 4

4

TD Economics model (green)

Oil gradually rises to $60pb by year end

3 2

Oil remains at $40

2 1

1

0

0 -1

3

Oil falls to $20pb by May and stays there

-1

01/07 05/07 09/07 01/08 05/08 09/08 01/09 05/09 09/09 01/10

*Forecasts by TD Economics as of January 2009 Source: Eurostat and Haver Analytics

ECB further room to cut rates, but it will take time for this expectation to firm. The two key factors to watch going forward to gauge the ECB’s bias will be Eurozone consumers and energy prices. The ECB’s expectation is that part of the recovery will be driven by consumers and their increased purchasing power driven by lower fuel prices. If this fails to materialize – and we believe credit tightness will inhibit consumer spending – then the ECB will need to revise their expectations for GDP growth lower. Second, given our sour economic sentiment, our models suggest that oil prices near $40 for 2009 (February-December) would be the level needed to drive inflation back to the 1.5%-2.0% level by year-end. Therefore, oil prices approaching $30 would help free the ECB’s hand to cut, while oil prices above $40 would likely drive the ECB to remain more hawkish. Richard Kelly, Senior Economist 416 982 2559 January 15, 2009

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TD Economics Commentary

January 15, 2009