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Policy officials and traders are quickly coming to the realization that the Euro Zone is heading towards a recession and financial crisis of its own. Confirming the bearish economic outlook, GDP contracted for the first time since records began back in 1995 with the second quarter reading.  Far more pressing (especially in the past few weeks and months) is the global credit crunch that has had a profound impact on most of the largest industrialized economies. The instability in the financial markets, led lending to virtually freeze on a number of occasions. What’s more, in the fray, a number of Europe’s largest banks required emergency funding to remain solvent. While ECB President Jean Claude Trichet hasn’t wavered from his inflation focus, markets suggest it is just a matter of time before the central bank caves. With tomorrow’s rate decision and statement we can see how soon that will happen.

 EZ 3 Month LIBOR vs ECB Rate Outlook 12 Months Out
 

The question that market participants and analysts are now debating is whether the ECB can wait until growth can naturally slow inflation, or if they need to act preemptively to avoid leading the economy to irreparable damage. Besides the argument between inflation and growth, there is the more immediate problem with the financial crisis. French and German officials have debated the necessity of a 300 billion euro bailout for the Euro Zone as Hype Real Estate, Fortis and Dexia have all flirted with failure. This is certainly a side effect of soaring short-term lending rates (blue line). Regardless of economists forecasts though, the market is expecting 100bps of easing over the next 12 months (orange line) and that drives the euro.