Is Europe's Central Bank Missing the Crisis?

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Throwing a lifeline to Europe's rapidly sinking economy, the European Central Bank today announced the deepest interest rate cut in its 10-year history, a clear sign that it has made rescuing the economy its top priority.

The ECB, which oversees the common currency in the 15-nation Euro zone, slashed its main lending rate three quarters of a percentage point to 2.5%, following two half percentage point cuts in October. Since credit markets are all but locked up in the wake of the collapse of Lehman Brothers in September, the ECB has ratcheted down its main lending rate by a total of 1.75 percentage points. (Read " Will Europe's Bank Bailout Plan Really Work?")

The difference in today's decision however was not just the size of the cut, but the message it sends about the central bank's thinking. Though the ECB remains more optimistic about the economic outlook than many economists, it seems finally to be coming to terms with economic reality. Just a few weeks ago, ECB president Jean-Claude Trichet justified the central bank's moderation in cutting rates by warning about continued high inflation. But speaking to reporters in Brussels, his emphasis was altogether different. "Overall, since our last meeting, evidence that inflation pressures are diminishing has increased," Trichet said. "Inflation rates are expected to be in line with price stability over the relevant policy horizon."

In the coded language of central bankers that means inflation is a non-issue at the moment and that Europe's monetary czars are now focused on ensuring that there is enough liquidity in circulation to keep the economy moving. With prices for oil and other major commodities falling, Trichet predicts a sharp drop in the inflation rate to between 1.1% and 1.7% next year from 3.2% to 3.4% this year. "This is a very significant rejection of everything that they've said before," said Jörg Krämer, chief economist at Commerzbank. "There will be a further interest rate cut in January. The main refinancing rate will be below 2% by spring."

Maybe so. But given the much steeper cuts that other central banks are making, the ECB move still seems modest in the face of the economic erosion under way. The Bank of England cut its key rate by one percentage point to 2% today, while Sweden's central bank cut its key rate by 1.75 percentage points. The U.S. Federal Reserve's main lending rate now stands at 1%, the lowest level in five decades.

The board that sets ECB monetary policy seems to be divided over the best way to deal with the financial crisis. When asked about the discussion behind closed doors, Trichet would say only that the board reached a "consensus" on its decision. But consensus does not mean unanimous and there is plenty of reason to believe that some members think the ECB is going too far, too fast.

As recently as Nov. 25, Lorenzo Bini Smaghi, a member of the ECB executive board warned that cutting rates too sharply could contribute to destabilizing financial markets rather than help calm them. And Trichet seemed to echo that concern, refusing to give any clear guidance about what direction the ECB may take when it meets again in January. "For January, I say nothing. It's as simple as that," he said. "We have to be sure that what we are doing is really effective."

Will the ECB begin to act more like the U.S. Federal Reserve and cut fast and deep? While it has flooded European markets with cash in recent months in an effort to revive the interbank lending market, it has not engaged in the purchase of assets from banks like the Fed. Trichet said the ECB has the power to do so, but is not showing his hand.

"It is hard to imagine the ECB pushing the quantitative easing boat as far into uncharted waters as the Fed has already done," said David Mackie, head of Western European economic research at JP Morgan, in a note to clients.

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