The European Central Bank has to cut official interest rates by at least another percentage point to stop the real cost of borrowing for households and firms jumping in the summer as inflation plummets.

That’s the logical conclusion of comments in recent weeks made by ECB policymakers including Italy’s Mario Draghi and Germany’s Axel Weber, who are watching inflation-adjusted borrowing costs closely to gauge the impact of cuts in official interest rates on the real economy.

One key factor in the euro zone’s economic recovery will be the real cost of borrowing, the interest rate paid on credit after adjusting for inflation, or any loss of purchasing power.

Although there is a long academic debate about how to calculate this, several policymakers have done a simple equation of taking annual inflation (1.1 percent in January) away from the current benchmark interest rate (2.0 percent) to arrive at an estimate of the real cost of borrowing of just under 1 percent.

“In the euro area the real short-term rate is now below 1 per cent; if official rates had not been cut, it would have risen considerably because of the fall in inflation,” Draghi said in a speech in Milan on Feb. 21. “The Governing Council is keeping a close watch on the real cost of money.”

The catch to this argument is that euro zone inflation is expected to fall to zero or lower in the middle of the year, which will push real borrowing costs up unless the ECB slashes official rates by an equivalent amount. If it keeps its refi rate at 2.0 percent, the real rate would also be 2 percent — or double the level it is now.

Economists fully expect the ECB to cut rates to 1.0 percent by the middle of the year, given the dismal outlook for growth as well as very low inflation. But they warn that the real rates argument could backfire on the ECB, which is already under fire for not having cut interest rates as aggressively as its peers in other countries, given inflation is expected to rise again in the second half of the year.

“Does that mean they would follow through by raising rates to compensate? That’s why I think they should be very cautious in using this argument,” said Deutsche Bank economist Mark Wall.

Economists are now certain the European Central Bank will cut interest rates again at its next meeting, the only question is how much.
ECB chief Jean-Claude Trichet’s blunt hint that a rate cut is possible, although not certain, at the next rate meeting on November 6 cemented expectations that the central bank is readying more ammunition to fire at the financial crisis.
Although Trichet would not be drawn on the size of the possible cut, using the past as a guide suggests it could be a repeat of Oct. 8’s half a percentage point reduction.
In June, Trichet flagged a quarter-point rate hike by saying that it was possible, although not certain that the ECB “could decide to move our rates by a small amount” — a qualification that was missing from Monday’s announcement.
   ”The absence of this language in today’s speech, suggests that the ECB President is leaving the door open to a bigger reduction,” Fortis Bank economist Nick Kounis said, tipping a half a percentage point cut to 3.25 percent.
Although the majority of its 25 rate changes have been by only 25 basis points, the pattern shows the ECB is more likely to be bold when cutting rates than when raising them.
Six of the nine rate cuts the ECB has undertaken since 1999 have been of 50 basis points, compared to only two of the 16 rate hikes.
The last two rate cuts, on Oct. 8 and before then in June 2003, were both 50 basis point moves — so the ECB could well go for three in a row.
Some have speculated that the ECB may even cut rates by 75 basis points, although it has never made such a large leap in its 10-year history, either up or down.

It was a routine press conference given by Canada’s Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney on the results of Friday’s G7 meeting.

After reassuring Canadian’s that they “probably have the most efficient, effective financial system in the world”, Carney was asked how Wednesday’s coordinated interest rate cut came together and who drove the process.

His answer revealed not only a “code of silence” among Central Bank leaders, but also hinted that those same leaders might have some special powers — at least if we are to believe they all independently decided an interest rate cut was a good idea at the exact same time.

Bank of Canada Governor Mark Carney