European Central bank deeply split on immediate rate cut

Fed move sparks ECB dilemma

By Ambrose Evans-Pritchard
The Telegraph, London
Friday, January 25, 2008

DAVOS, Switzerland -- A serious conflict at the European Central Bank has broken into the open after Spain's finance minister revealed that a number of board members are pushing for an immediate rate cut in light of the emergency action by the US Federal Reserve week.

Pedro Solbes, the former EU monetary commissioner and now Spain's deputy premier, confirmed persistent reports that there had been a tug-of-war at the ECB headquarters, belying the facade of unity.

"An important debate is going on within the European Central Bank over whether or not to cut interest rates," he told the television station Telecinco.

While he did not elaborate, it appears that a bloc of governors from southern Europe and probably Ireland are deeply at odds with the hawkish anti-inflation stance of the German Bundesbank.

Jean-Claude Trichet, the ECB's president, gave no hint of the disagreements in a talk at the World Economic Forum in Davos. He stuck rigidly to the script that the chief threat to the eurozone is inflation, which reached 3.1 percent in December -- the highest since the launch of the euro. "There is one needle in our compass -- price stability," he said.

This is "no time for complacency" over inflation, he said, implicitly playing down the danger of a credit implosion. The ECB continues to hold rates at 4 percent. It has made no change since the credit crunch hit in August. Axel Weber, the hard-line Bundesbank chief, went further, insisting that rates are "still on the accommodative side and in no way restrictive."

This may be true for Germany, which is lean after driving down wages, but it is another matter for Latin-bloc countries. Spain's property bubble has burst, with prices falling in most of its cities.

Former US Treasury Secretary Larry Summers said the picture seemed to be darkening rapidly. "The outlook for Europe is being revised downwards," he said.

Julian Callow, Europe economist at Barclays Capital, wants a half-point cut in eurozone rates by May. He slashed his growth forecast to 1.5 percent in 2008.

The Spanish banks have been unable to place mortgage security debt on the market for five months, and are reportedly hoarding up to E40 billion (L30 billion) in unsold issues for use as collateral at the ECB's liquidity window -- if necessary.

Italian bonds are under heavy pressure as the Prodi coalition disintegrates, increasing the risk of a euro-sceptic government. Until now the German orthodoxy has largely passed unchallenged but the crisis has brought tensions to a head.

Even the Austrian and Luxembourg governors -- often described as the "attack dogs" of the Bundesbank bloc -- have changed their tune, highlighting the growing risks of an economic downturn.

On the currency markets, the euro has failed to rally since the US rate cuts and the markets are betting that the ECB will be forced to cut rates soon.

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