Likely EU Recession Paves the Way for Greater ECB Influence

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By Jason Simpkins
Associate Editor
Money Morning

The European Commission (EC) said yesterday (Monday) that the Eurozone economy has already slipped into a recession and strong and stable economic growth will not return until 2010. The European Central Bank (ECB), originally charged with the task of maintaining price stability, has now found itself with the added responsibility of encouraging growth and will likely cut interest rates later this week.

Gross domestic product (GDP) in the 15-nation Eurozone probably contracted by 0.1% in the third quarter after shrinking 0.2% in the second, the European Commission said. The executive branch of the European Union also lowered its 2008 forecast to 1.2% as the economy contracts another 0.1% in the fourth quarter.

For all 27 EU countries, the commission expects the economy to expand 0.2% next year.

"The economic horizon has now significantly darkened as the European Union economy is hit by the financial crisis that deepened during the autumn and is taking a toll on business and consumers," EU Economic Affairs Commissioner Joaquin Almunia said in a statement. "In 2009, the EU economy is expected to grind to a standstill."

The EC predicted economic growth in the region will be a paltry 0.1% in 2009. However, many analysts – including those with BNP Paribas SA (OTC: BNPQY), Citigroup Inc. (C) and Royal Bank of Scotland PLC (RBS) – believe even that figure is generous.

"A recession in 2009 seems now unavoidable," Jacques Cailloux, chief Eurozone economist at Royal Bank of Scotland, told Bloomberg. "Today's new GDP forecast of 0.1% for 2009 by the European Commission still looks too optimistic to us."

The Eurozone Purchasing Managers' Index – a measure of manufacturing output, new orders and volume of new export orders – fell for the fifth consecutive month in October, hitting a record low 41.1. A reading below 50 for the index represents contraction.

Unemployment in the Eurozone remained stagnant at 7.5% in September, but the EC expects the jobless rate to soar as high as 8.4% in 2009.

It's likely that Germany, France and Italy have already entered into a recession, as their second-quarter GDP fell 0.5%, 0.3% and 0.3%, respectively.

The EU acknowledged that its forecasts for the Eurozone, as well as the economy of the 27-member European Union, could worsen if the credit crunch continues unabated.

Even slightly higher borrowing costs could significantly restrict the amount of credit available to households and "trigger an outright recession, a decline of 1% of GDP in the euro area," the EC said.

The only silver lining is what the EU predicts will be a marked cooling of inflationary pressures. Slackening demand has driven down the prices of commodities across the board, dampening inflation, at least for the short term.

The EC said yesterday that inflation would ease from 3.5% this year to 2.2% in 2009. With inflation on the decline the European Central Bank has the opportunity to cut interest rates to promote growth, which it is expected to do Thursday.

Analysts say the ECB, which raised rates in July, could cut its benchmark interest rate by a half a point Thursday. Should the economic downturn persist into next year, the central bank could cut the current 3.75% rate to 2.5% by April.

That would make for the fastest round of rate cuts in the central bank's 10-year history. It would also mark a deviation from the ECB's original mandate.

A New Role for the ECB

The ECB's primary objective is "to maintain price stability," and after that to "support the general economic policies of the Community." However, as the global financial crisis has deepened, the role of the European Central Bank has expanded well beyond this initial mandate.

Like the Fed, the ECB has taken the opportunity presented by the financial crisis to broaden its role.

Last month, the ECB offered a $6.4 billion loan to Hungary and Hungarian Prime Minister Ferenc Gyurcsany said he's lobbying policymakers to allow the ECB to provide liquidity outside the euro area.

The ECB has increased lending to Eurozone banks to more than $1 trillion.

The central bank also set up currency swaps with Denmark and Switzerland. The ECB gave Denmark access to about $15 billion (12 billion euros) in an effort to "improve liquidity in euro short-term markets."

All of these measures lie outside of the ECB's stated objectives.

"The ECB is at times playing the role of lender of last resort for the whole European financial system," Guillaume Menuet, a senior European economist at Merrill Lynch & Co. (MER), told Bloomberg. "Its mandate is being implicitly expanded."

While ECB President Jean-Claude Trichet clearly holds sway over the 15 nations that use the euro, no other institution or authority exists to offer financial assistance to the outlying members of the European Union.

However, given the steps taken by the ECB to assist countries such as Hungary, Trichet could soon find himself with authority and influence over a much larger territory. And perhaps a new mission.

"My dream is that the ECB gets a financial stability mandate, which is not the case so far," Natacha Valla, a former ECB economist at Goldman Sachs Group Inc. (GS), told Bloomberg. "The ECB really has demonstrated it can fulfill such a mandate."

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