The case for a fresh round of monetary stimulus

WHEN the European Central Bank (ECB)’s council meets in Frankfurt this week, it faces a dilemma. Should it do the right thing and cut rates? Or should it sit tight and hope that the economic outlook improves and that history will judge its two recent rate hikes favourably? Sadly, I suspect that pride will come before a fall (in rates).

What must be clear even to the men in their Frankfurt tower is that the outlook below has darkened substantially. Even the German export machine is now stalling and the situation further afield in places like Spain, Italy, and Greece is downright grim. It must also now be apparent that the inflation genie is still in the bottle and the risk to price stability is minimal. Raising rates in the first place was a mistake.

To make matters worse, the ECB is being made to look foolish on another front. Under intense political pressure the governing council agreed last month to start buying Italian bonds. Since then it has probably picked up close to €60bn worth of debt. The quid pro quo for this was that Italy should get its house in order and back aggressive austerity. Silvio Berlusconi initially seemed to be on board but his acceptance of the ECB’s authority has waned and so has his austerity zeal. The Italian 10 year yield is now back above five per cent and it will be interesting to see in today’s release from the Securities Markets Programme whether the central bank is still in the market.

So what should the ECB do? The chance of an imminent rate cut is small. The governing council would need some sort of cover to make such a huge volte-face. This cover might be available, however. A coordinated action that would see Washington (and probably London) launch more monetary stimulus alongside an ECB rate cut of (say) half a per cent might work for everybody.

Such a decision would also signal to the markets that the one organisation in Europe that probably has the power to avert a collapse in the Eurozone is still in the game in a big way. With politicians foundering on the rocks of indecision, the ECB must do more. The central bank can and must help Greece, which is in spitting distance of a hard default, even if this means throwing the rule book out of the window. Outgoing ECB boss Jean-Claude Trichet may not see the euro project fall apart on his watch but the decisions he makes before the end of October could still prove pivotal.

Guy Johnson co-anchors CNBC’s European closing bell.