ECB Meeting Preview

June 4, 2008

The ECB will announce no change in benchmark interest rates at 11:45 GMT tomorrow. The key refinancing rate has been at 4.0% for the past twelve months. New quarterly staff forecasts of GDP growth and CPI inflation in 2008 and 2009 will be unveiled at a press conference that starts at 12:30 GMT. 2008 growth in 2008 was projected to lie within a 1.8-2.6% range in forecasts made a year ago and repeated last September, but such was revised downward in December to a range of 1.5-2.5% and revised further downward three months ago to 1.3-2.1%. A growth forecast for 2009 was first introduced last December as a range of 1.6-2.6% and reduced to 1.3-2.3% this past March. The latest 1.3-2.1% growth corridor projected for this year still appears to be a reasonable estimate and will not be revised much, if at all. However, the GDP forecast for 2009 is likely to get revised lower.

The outlook for inflation has deteriorated by more than that for growth. In June 2007, projected CPI inflation in 2008 was put at 1.4-2.6%, more or less straddling its target ceiling of “below but close to 2%.” The ECB’s CPI forecast was bumped up to 1.5-2.5% in September, 2.0-3.0% in December, and 2.6-3.2% in March, and a further increase will be unveiled now. Projected 2009 CPI inflation was introduced at 1.2-2.4% last December and raised to 1.5-2.7% in March, which would be still close to target. Regrettably, the March forecast now looks too low, as ECB officials now concede a protracted period of high inflation. Consumer price inflation in May matched the peak of 3.6% in March and was more than twice as great as 1.7% last August when the credit crunch began. Producer price inflation has meanwhile accelerated also to 6.1% y/y and 3.7% excluding energy.

The growth forecasts overstate the momentum of activity and reflect mostly stronger-than-heretofore assumed first-quarter growth of 0.8% (i.e., more than 3.0% in annualized terms). Consumer sentiment is now floundering, and the composite PMI of 51.1 in May is the lowest such has been since July 2003, a time when the refinancing rate was at 4.5%. However, back then, CPI inflation was at 1.9% compared to 3.6% now, M3 was expanding at an 8.5% on-year rate versus 10.7% now, and private credit was advancing 5.5% y/y compared to 11.8% now. With a sole mandate to guard price stability, officials have no leeway to consider easing credit policy or to even hint that they might do so in the future, lest expected inflation be lifted as a result.

The volume of retail sales in Euroland dropped in February, March and April by a total of 1.7%, and a drop of 2.9% from April 2007 represents a low for this data series. Both EUR/USD and oil prices are near to levels on May 8th, when the ECB Governing Council last met. The decision to keep interest rates steady at that meeting was a unanimous one, and nobody even suggested raising or lower the 4.0%, which was considered an appropriate level for achieving the ECB’s objectives. The tone of remarks at the May press conference and by ECB officials over the past month was hawkish.

The main mystery heading into tomorrow’s press conference is whether the remarks become even more hawkish. Escalating warnings against inflation and fortified threats to do whatever needs doing to anchor expected price rises can always be justified at a time when projected inflation is being raised. The wild card is the euro, which officials consider overvalued. Bernanke’s Tuesday remarks were certainly run by Treasury beforehand, and some coordination of foreign exchange policy may be under way with the ECB, too. Trichet will not want to undermine the gist of Bernanke’s comments on the dollar, but I’m confident he can find the right words to express a high state of alertness about Euroland inflation without sending the euro sharply higher.

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