ECB under pressure to cut rates amid fears of a new recession

The bank raised rates by a quarter point in April and again in July to the current 1.5 per cent to ward off what then appeared to be growing inflationary pressures. But since then Europe’s government debt crisis has worsened and in recent days leading indicators have soured.

“Pressure is mounting on the ECB to quickly reverse its recent monetary policy tightening cycle rather than just halting it, with a near-term interest rate cut,” said Howard Archer, chief European economist at IHS Global Insight.

Jim Leaviss, fund manager and head of retail fixed interest at M&G Investments described the decision to hike rates twice this year as a “policy error” and said they came at a “terrible time in the recovery”.

The bank’s 23-member governing council next meets on 6 October in Berlin. Bank president Jean-Claude Trichet made it clear at a news conference on 8 September that the ECB had halted its series of increases because the growth outlook had worsened and inflation risks had eased.

A run of downbeat data in recent days, including a closely-watched index of industrial activity that registered outright contraction, and a dip in eurozone consumer confidence and industrial orders, has tilted the balance in favour of an imminent rate cut.

Royal Bank of Scotland economists said yesterday that they reckon there is a 60 per cent chance the bank will slash rates by a half-percentage point at the 6 October meeting. If the governing council can’t agree on an October cut, then RBS sees one in November or even between meetings; the council can confer and decide rates at any time.

Last month RBS expected a 40 per cent chance of lower rates by year end. But the worsening economic outlook led to a shift in the prediction; the bank’s economists now predict a eurozone recession, or drop in economic output. Not all economists agree, however. Christoph Balz at Commerzbank reckons it would take a further worsening of the economic outlook, or a sudden escalation of the debt crisis, for the ECB to cut rates.

“The central bank will only consider a move on rates if it has to substantially trim back its recently lowered projections – provided the sovereign debt crisis does not escalate,” he said.

The likelihood of a rate cut came as Europe’s banks face a capital hole of at least €200 billion (£175bn) if Greece forces them to slash the value of its debt and other troubled eurozone countries such as Italy and Ireland follow suit, says the International Monetary Fund.

Banking analysts are even gloomier, with Credit Suisse calculating that banks may need €400bn by 2012 to fill a hole left by a recession, losses on sovereign debt and higher funding costs. Barclays Capital estimated European banks could need about €230bn to preserve a core Tier 1 capital ratio of 6 per cent in the extreme case they lose half the value of Greece, Irish, Italian, Portuguese and Spanish debt.

But private investors are clear that they will not provide the money to stop the capital gap such write-downs would cause for as long as Europe struggles to find a joined-up strategy to exit its spiralling debt crisis.

Greece’s government said it was still focusing on getting its second bail-out done, but a statement from the French regulator saying that 15 to 20 banks needed more capital kept the worries about Europe’s banks firmly in place.

Moody’s downgraded eight Greek banks, citing their exposure to their government’s bonds and the deteriorating economic situation.