Banking crisis, weak growth raise pressure

October 2, 2008

, FRANKFURT, October 2 – The global banking crisis and weak economic growth have increased the pressure on the European Central Bank to cut interest rates but it will likely opt for no change again on Thursday, economists say.

Concern that higher wages could stoke inflation "may tie the ECB\’s hands for the time being" and ensure its main lending rate stays at 4.25 percent, UniCredit Markets economist Nikolaus Keis said.

"Grave ECB concerns about rising wage inflation still make the bank reluctant to take the risk of cutting \’too soon,\’," Bank of America economist Gilles Moec added.

Eurozone inflation has eased to 3.6 percent but that is still way above the bank\’s target of just below 2.0 percent and ECB president Jean-Claude Trichet stresses that fighting rising prices is the bank\’s top priority.

Meanwhile, however, manufacturing activity fell again in September according to a key purchasing managers\’ index that languished in contraction territory for the fourth month running.

Unemployment has also started to creep back up in many eurozone countries.

"What started as a knee-jerk reaction to the inflation shock increasingly looks like a self-reinforcing negative spiral," Moec said.

Above all, the international banking crisis is generating alarmist headlines that fuel concern in many European financial capitals.

"In the past four days, the governments of no less than seven European countries were required to nationalize banks or guarantee the deposits of large cross-border institutions," US economics professor Nouriel Roubini said on Wednesday.

Speaking on Tuesday, Trichet noted the ECB had been tested many times in its 10-year history, including by the September 11, 2001 attacks in the United States.

"The emergence of the financial market tensions in August 2007 is certainly the most challenging experience to date," he concluded.

Central banks including the ECB and US Federal Reserve have pumped cash into interbank money markets to keep credit flowing but those operations may have reached their limits and calls for rate cuts have grown.

The Fed\’s key interest rate now stands at 2.0 percent however, which does not leave the US central bank much room for manoeuvre and cuts are not likely to resolve a toxic lack of trust between commercial banks.

"The fundamental reason why the money market stopped functioning is because banks do not trust each other," UBS economist Stephane Deo said.

Commercial banks face such uncertainty that lending to each other has ground to halt, leaving the central banks, as the Wall Street Journal Europe noted, as lenders of \’first resort,\’ not last resort, as is their traditional role.

Against this backdrop of financial turmoil, analysts will be listening closely for what Trichet has to say about the economic outlook and especially on employment.

When Trichet speaks Thursday following the rate decision, "we will look carefully for any sign of a more cautious labour market assessment" that could point to weaker economic forecasts, UniCredit economist Marco Valli said.

"This would be an important signal on the way to rate cuts."

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