ECB Meeting Preview

May 7, 2008

I expect the European Central Bank Governing Council to decide unanimously to retain the interest rate structure that has been in place since a 25-bp increase last June. There were eight increases, all by 25 basis points, between December 2005 and June 2007. A signal of plans to hike rates a ninth time was conveyed after the August 2007 meeting but quickly aborted, overtaken by global credit market turbulence. And that’s where things have stood for the last eight months, with a refinancing rate of 4.0% offering a scant real return set against on-year CPI inflation of 3.3% in April and 3.6% in March. Money and credit continue to expand at faster-than-10% rates from a year earlier and, despite some distortions, have been called “vigorous” by ECB officials. I do not expect a change tomorrow in their relentless insistence that price risks are skewed to the upside. Their baseline CPI forecast foresees a “protracted period” of inflation holding above the target ceiling of “below but close to 2%,” and the actual path of inflation is more likely to exceed than undershoot that baseline case. In normal financial times, the ECB might have raised rates by now to at least 5.0%, but extremely high uncertainty prevents an aggressive anti-inflationary stance.

A second deterrent, weakening growth prospects, creates the possibility of a rate cut late this year but only if economic activity worsens demonstrably and shows signs of reducing inflation. ECB officials through their April press conference had tenaciously predicted that growth would moderate but continue at an acceptable pace. It will be hard not to modify that prediction now. Real retail sales in the Ezone climbed just 0.6% saar in 1Q08. The composite PMI (encompassing both manufacturing and service-producing industries) fell to 51.9 in April from a 1Q average reading of 52.1. Such has dropped from 54.7 last October and 57.5 in July before the credit crisis. It’s not just dysfunctional credit markets and weaker U.S. demand. The euro’s appreciation and commodity-driven higher inflation also have hurt the economic outlook. Economic sentiment of 97.1 in April represented a 32-month low and compared to an average score in 1Q08 of 100.5. Producer prices in the zone accelarated to an annualized pace of 7.8% in 1Q08 from 5.2% in 4Q07. And just today, Germany reported a fourth straight monthly decline in industrial orders, which also slumped 5.2% saar in 1Q08.

ECB President Trichet has a diplomatic task to perform at tomorrow’s press conference, balancing a more precarious growth outlook against intensifying inflationary pressure. Those who look for a clearly more dovish tone and hints of a rate cut by summer are apt to be disappointed. The message will be more nuanced. When push comes to shove, Trichet and the Governing Council have consistently erred on the side of taking a strong stand against allowing any risks of higher inflation. They in fact generally speak more hawkishly than they act.



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