Risk Management

Tumbling Rates

Europe's central banks embark on a day of big interest-rate cuts.
Economist StaffDecember 4, 2008

As European economies have weakened far more than expected, their central banks have wielded their big weapon. Thursday December 4th will go down in monetary history as the day that they made drastic cuts in interest rates to ward off a severe recession.

It started with a bang when the Swedish central bank announced a far bigger reduction than expected in its policy rate. At a meeting brought forward from mid-December, the bank’s executive board lowered the repo rate from 3.75 percent to 2 percent. Economists had anticipated a much smaller cut — of up to a percentage point.

Explaining the decision, the board said there had been an unexpectedly rapid and clear deterioration in economic activity since October. The scale of the reduction was also necessary because monetary policy was less effective than usual. Even with the policy rate at 2 percent the bank is now forecasting that the Swedish economy will shrink by 0.5 percent next year; in October it had expected growth of 0.1 percent.

At mid-day it was the turn of Britain’s central bank to enter the jousts. The Bank of England had already cut its policy rate from 4.5 percent to 3 percent in November. It followed up this up with another big reduction, bringing the base rate down down to 2 percent, the lowest since 1951; indeed the base rate has never fallen below this level since the Bank of England was founded in 1694.

As in Sweden, the scale of the cut in Britain’s official interest rates reflected a sharp worsening in the outlook for output and a recognition that monetary policy is currently impaired by the banking crisis. A string of reports this week showed a sharp fall in activity in manufacturing, construction and private services in November. Taking all three surveys together, they point to GDP declining by 0.8 percent or 0.9 percent in the fourth quarter compared with the previous one, an even bigger contraction than the 0.5 percent fall in the previous three-month period, according to Vicky Redwood of Capital Economics, a consultancy.

Britain is also facing a worse recession than Sweden in 2009. Last week the Treasury unveiled a fiscal stimulus worth around 1 percent of GDP in the next financial year. The centrepiece is a temporary reduction in the main rate of value-added tax from 17.5 percent to 15 percent, a change which came into effect on December 1st and will last until the end of 2009. Yet even with this boost, the Treasury’s central forecast was for GDP to fall by 1 percent next year; and even that may prove optimistic.

The outlook for the British economy is particularly dire because it has been hit so hard by the banking crisis. Policymakers are particularly concerned about a collapse in credit growth. Although broad measures of lending are quite buoyant they are distorted by the activities of specialist financial intermediaries. Lending to the sectors that matter — households and non-financial companies — has essentially stalled since the summer.

Unlike Britain’s rate-setters, the European Central Bank has typically been cautious about making big moves in interest rates. Since 1999, the most it has reduced them in one month is by half a percentage point — most recently in October and November, bringing the benchmark rate down from 4.25 percent to 3.25 percent. But its decision today to cut rates by three-quarters of a percentage point was expected, for two main reasons.

First, euro-area inflation has swooned: it fell from 3.2 percent in the year to October to 2.1 percent according to an initial estimate from Eurostat. And second, the euro area is already in recession. Figures released today confirmed that GDP declined by 0.2 percent in the third quarter compared with the previous one, following a similar decline in the second quarter.

The day of big rate cuts brings relief as European central banks ride to the rescue. But it also may arouse fear. It shows just how worried they are about the economic downturn.