FRANKFURT (MNI) – The European Central Bank should cut interest
rates further, continue non-standard liquidity support as planned and
prepare for more radical measures should the monetary transmission
mechanism become seriously impaired, the OECD said in its Economic
Outlook on Monday.

“Given the slowdown in activity at a time of existing spare
capacity and weak underlying inflationary pressures, policy rates should
be lowered and non-standard measures continued as planned with the aim
of reducing the overnight interbank rate to a very low level,” the
report said.

The ECB cut interest rates by 25 bps to 1.25% earlier this month
and has committed to continue the fixed-rate, full-allottment procedures
for its refinancing operations. It expanded the maturity of those
operations, adding a 12-month and a 13-month LTRO.

The OECD expects Eurozone economic output to “contract modestly in
the final quarter of 2011 and the first quarter of 2012″ before staging
a “muted” recovery from mid-2012, the OECD said. Eurozone GDP is
expected to drop to 0.2% in 2012 before recovering to 1.4% in 2013.

Along with growth, inflation is expected to drop well below the
ECB’s price stability level of close to but below 2.0%, allowing for
looser monetary policy. The OECD projects HICP to drop to 1.6% in 2012
and 1.2% in 2013.

Risks to this outlook are on the downside and “center on the
interactions of slow growth, sovereign debt and weaknesses in the
banking system, as well as the ability of policymakers to find a
credible solution to the debt crisis,” the report said.

Along with looser monetary policy and generous liquidity provisions
to counter interbank lending tensions, the OECD called for a range of
policies to break the negative feedback loop:

“A rigorous and credible assessment of all risks to the banking
sector is required and measures [should be] taken to ensure that all
banks are well capitalized as currently planned,” the report said.
“Appropriate policy measures should be taken, including a large-scale
recapitalization. EFSF funds should be made available where necessary.”

At the same time, “euro countries should pursue the consolidation
plans set out in Stability Programmes.” Countries facing severe fiscal
problems in particular must set out “more detailed and credible plans
for fiscal consolidation” as soon as possible to enhance the credibility
of current plans.

Should policy-makers fail to contain contagion and downside risks
do materialize, “the expanded scope of the EFSF should be used as
necessary to maintain stability in the euro area, to address sovereign
and banking problems,” the OECD said. “The resources available for
intervention have to be at a level where market confidence would be
regained.”

“Where solvency problems are identified, a voluntary private sector
debt restructuring should take place as anticipated in the ESM and new
financing arrangements should be put in place by official creditors,”
the OECD said. The OECD did not specify whether it favours any possible
PSI — beyond Greece — even before the ESM becomes effective in 2013.

The OECD also joined international calls for the ECB to prepare for
more radical action. Should the monetary policy transmission in the euro
area as a whole become “more seriously impaired”, the ECB will have to
pursue “more radical, non-standard measures,” the OECD said.

While not explicitly citing more aggressive bond buys, the
reference to the monetary transmission mechanism — which the ECB cites
as the reason for its bond market interventions — makes clear that this
is what the OECD is referring to.

Thus far, the ECB has publicly rejected the option of more
aggressive intervention, arguing that it would impair its independence
and remove much needed pressure on fiscal authorities to push ahead
with fiscal adjustments.

–Frankfurt bureau tel.: +49-69-720142. Email: jtreeck@marketnews.com

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