ECB set to hold rates, Trichet to growl at inflation

At last month’s meeting the European Central Bank lifted euro zone interest rates to a near 7-year high of 4.25% from 4%, the first move in a year and a step aimed at stomping on surging inflation, then at 4.0%.

The bad news for the ECB is that inflation has since ticked up to a record 4.1%. The good news is that some analysts think the worst could be over thanks to a 20% fall in oil prices over the last month.

Traditionally the ECB deemed it unnecessary to hamper August holiday plans with the inconvenience of a face-to-face meeting in Frankfurt, but last year’s credit market crisis altered protocol and at 0700 GMT governing council members will meet at the bank’s headquarters. At 1145 GMT the ECB will announce the rate decision then at 1230 GMT Trichet and Vice-President Lucas Papademos will talk through the decision at a news conference. All 85 analysts polled by Reuters last week expect the ECB to leave rates at 4.25% this time around. The poll result comes as little surprise.

The Frankfurt-based central bank has not raised rates twice in a row since mid-2000, and with the global economy still hobbled by the credit crisis, economists always expected the ECB to let the dust settle after last month’s excitement. However further rate hikes this year, once heavily tipped by financial markets, are now just an outside bet with two in three analysts now forecasting a cut by the end of 2009. Pricing derived from Euro Overnight Index Average (EONIA) rates now shows only around a 30% chance of another ECB rate increase this year, down from 75% a month ago according to traders.

There are two main reasons for the dramatic shift. The first is that Trichet persuaded market watchers that a series of hikes were not in the ECB’s game plan with the line last month that the bank had “no bias” on future rate changes. The second is that the latest swathe of economic data from the 15-country bloc made disturbing reading for firms and politicians under pressure to deliver higher profits and rising living standards.

 
GROWTH PAINS

Many euro zone economic indicators hit their lowest levels since 2003 in recent weeks, and falling services sector morale and tumbling retail sales in the past few days delivered fresh blows. The services sector, which makes up roughly two thirds of the euro zone economy, contracted at its fastest pace in five years in July -- a statistic mirrored in the manufacturing sector -- while euro zone retail sales, an indication of consumer demand, saw their biggest ever annual fall in June.

Up until now Trichet has repeatedly assured observers that the European economy “remains sound” but some analysts believe he may now have to acknowledge that all is not well. “The ECB Governing Council has probably been surprised by the weakness of the data flow. However, it would be difficult for it to make a U-turn in its economic analysis just one month after hiking rates,” said Lehman Brothers analyst Lavinia Santovetti. “Nonetheless, we think that there is room for a clearer acknowledgment of the deterioration of the growth outlook,” she added. “A stronger step would be to mention clearly that there are increased downside risks to growth.”

Others believe that Trichet will concentrate solely on inflation, because it is the ECB’s primary responsibility and is running at more than double its target of just under 2%. “Risks here remain towards a more hawkish slant, particularly from the ECB with central banks in general quite unwilling to call an end to the inflation crisis until more definitive evidence arises,” said Sean Maloney, bond strategist at Nomura in London.

While Trichet is more likely to wait until next month when ECB staff have updated their projections to comment, he would argue that he has always said the Q2 would be tough following a blockbuster first three months for the euro zone. But it may not be quite as simple as that. The ECB’s number crunchers, and probably its policymakers too, never factored in the possibility that oil prices would flirt with $150 in July, a fact that has made companies wince and hit Europeans’ wallets.

However crude prices have now dropped $30, trading below $120 a barrel for the first time since early May. The plunge has been put down to a lull in nuclear tensions with Iran and the belief a US and global slowdown will slacken demand. But oil traders know it could well spike back up, if problems with Iran reignite and the US manages to bolster its economy in the coming months. (Reuters)