12 November 2007

EZA819: ECB Observer

ECB 8 November Council Post-Meeting Assessment


· As expected, ECB's key rates kept on hold on 8 November, leaving 'refi' rate at 4%, due to financial market turmoil and continuing uncertainty about its economic repercussions.

· ECB still maintains growth outlook sound, albeit subject to downside risks, but greater than expected jump in 'headline' inflation rate, from 2.1% to 2.6%, causes increased concern about potential impact on inflation expectations and second-round effects

· Inflation expected to remain "significantly above" 2% during 2007 Q4 and in early 2008 before moderating, and upside risks to price stability remain.

· Continuing strong money and credit growth remain a key concern, with possible distortions due to temporary or special financial market factors now slightly down-played.

· Reassertion that overriding concern is risks to price stability, rather than financial stability or growth, but proper functioning of money markets also needs to be ensured.

· As a month ago, monetary policy stands ready to counter upside risks to price stability and the Governing Council will monitor closely all developments before drawing further conclusions for monetary policy and act in a firm and timely manner to ensure risks to price stability do not materialise, as well as paying great attention to financial market developments over the period to come.



EZA Conclusion: Governing Council remains in wait-and-see mode with a bias toward tightening. This further tilt towards concerns about possible rise in inflation expectations and second-round effects, despite delay in normalisation of financial market conditions, poses a dilemma for ECB but Trichet repeats the primacy of the ECB's price stability objective, while also stressing the separate need to ensure the proper functioning of money markets. EZA's central view therefore remains that the ECB will remain in wait-and-see mode for some time, providing money market liquidity when necessary, until the financial situation improves or inflation risks become more acute and imminent. In this scenario, we would see the 'refi' rate being raised to 4 1/4% around the middle of 2008. If, instead, there were a marked further deterioration in financial market conditions, the Governing Council could find itself obliged to cut rates - probably to 3 1/2% in the first instance - on the clear understanding that this would be reversed as soon as financial conditions returned to normal.

© Graham Bishop