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Thursday May 10, 05:07 PM

ECB cuts rates in shock about-face

By Jonathan Gould and Tomasz Janowski

FRANKFURT (Reuters) - The European Central Bank has caught markets wrong-footed with a quarter point interest rate cut, saying new evidence of money supply slowdown made it more confident it could keep inflation in check.

The ECB lowered its key lending rate to 4.50 percent from 4.75 percent in only its second ever policy easing since the euro's 1999 launch.

The move came as a shock to the market after the central bank sought for weeks to quell expectations that slowing euro zone growth would force it to join other major central banks in reducing interest rates.

The cut followed a similar but widely expected quarter point reduction by the Bank of England of its interest rates earlier in the day.

Analysts said the ECB's move renewed concerns about the bank's ability to communicate its intentions to the markets and could hurt its credibility.

But ECB President Wim Duisenberg said the bank was able to lower borrowing costs because latest data suggested price pressures could be contained in the medium term despite temporary blips in food or energy prices.

"Over the medium term, in 1-1/2 to two years, all the forecasts that are available indicate that inflation will be under two percent again," he said, referring to the bank's ceiling for price growth.

He also said the cut, which he called an adjustment, was possible because M3 money supply, one of the two planks of the ECB's strategy, was moderating faster than earlier assumed.

"There have been indications that monetary growth figures are distorted upwards by non-euro area purchases of negotiable paper included in M3. This is has been confirmed by clear evidence," he said.

The bank's new insight into the monetary statistics allowed it to conclude that rather than hovering above the ECB's 4-1/2 percent benchmark, the M3 growth had already dipped below it in the past months.

"Taking into account the latest available information, monetary developments no longer pose a risk to price stability," Duisenberg he said, adding to more subdued economic growth also helped contain price pressures.

WAIT-AND-SEE INTACT?

He refused to be drawn into a discussion whether the move signalled the start of an easing cycle after seven interest increases in 1999 and 2000.

But Bundesbank President Ernst Welteke, who is also a member of the ECB's policymaking council, told reporters that Thursday's move should be seen as a "adjustment to policy" and not a change of direction.

"From now on the ECB stance is wait-and-see again but at a different level," he said.

The message was reinforced by his Finnish counterpart Matti Vanhala, who also played down the prospects of further easing.

"Today we did not start from the (idea) that this would somehow be the first in a series of rate cuts," he told reporters.

Economists have long believed that the ECB did not need to lose sleep over money supply but the sudden shift of focus to M3 indicators away from price data, which make up the second pillar of ECB's strategy, raised several eyebrows.

"The view he (Duisenberg) is giving is one we had a couple of months ago. They seem to have changed their minds about what is important and he is not managing to justify the decision very well," said Hans Jaeckel of DG Bank in Frankfurt.

"A rate cut is appropriate for the European economy, but the timing is a problem."

SUDDEN ABOUT-FACE

The ECB has for months resisted international pressure to cut its rates despite evidence that the European economy was not able to completely shrug off the impact of a marked U.S. economic slowdown.

Only last week, it firmly rebuked calls for a cut, including those from the International Monetary Fund. As a result, all but three of the 50 analysts polled by Reuters had expected it to stay on hold until June at the earliest.

Analysts said, however, that the bank had to change its tack after this week's data flashed a warning light over the health of the German economy, Europe's largest. The M3 revisions just helped it justify a turnaround.

Some said late is better than never, given the slowing European growth.

"It's a good thing for the European economy," said Bernard Walschots at RaboBank in the Netherlands.

"Finally they have woken up and I guess the bad numbers from Germany at the start of the week have made them realise they had gone too far in denying the need for a rate cut," he added.

Gloomy industrial production, orders and jobs data this week from Germany had raised fears of a serious slowdown at the heart of the common currency bloc.

Germany, which makes up one third of the 12 nation euro bloc's economy, surprised markets earlier this week with a sharp drop in industrial output and manufacturing orders in March, while unemployment rose for the fourth month in a row in April.

CREDIBILITY AT STAKE

But several said the ECB's about-face hurt the bank's already patchy credibility.

The euro, which spiked on the announcement, reversed the gains as traders reacted with fury to what was perceived as trying to wrong-foot the market.

"I don't think it says a lot for credibility at the ECB to be honest. It has not been signalled at all to the market...It doesn't sit very well with comments we have had out of the ECB," Steven Pearson at the Halifax in London said.

Recent ECB comments signalled it was more worried about price pressures, with inflation running at 2.6 percent in March and likely to edge up again in April. Markets might have disagreed, but seemed to appreciate the central bank's consistency and resolve to focus on inflation.

The impression that it has now succumbed to growth concerns was seen as a confusing signal, meaning the young central bank has not yet mastered communication with the market.

"It really means that transparency is not an issue as far as they are concerned," Jeremy Hawkins at Bank of America in London.

European financial leaders have stuck doggedly to the line that the region will retain growth at or above its long-term trend level of 2.5 percent.

Duisenberg tried to stick to that line at the Thursday news conference, dismissing the German data as "anecdotal evidence".

Frequently asked at the news conference if the surprise it sprang on markets was good for its credibility, the solemn looking central banker said: "It is not our intention to surprise markets, but sometimes it is unavoidable."

-- (M@rket.trends), May 11, 2001