03 June 2008

EZA 847 Report: ECB Observer

ECB 5 June Council Preview

NO RATE CHANGE FORESEEN FOR 5 JUNE: RATES SEEN ON HOLD WELL INTO H2 2008 AND RATE RISE BY END-2008 STILL NOT RULED OUT

· 'Headline' inflation rate shoots back up from 3.3%to 3.6% in May despite favourable year-ago statistical effects: risks of second-round wage-price spiral remain, with continuing external cost pressures, domestic pass-through to prices, and rising labour costs.

· Further signs that economic activity has been slowing significantly over the past few months, with confidence in the manufacturing, consumer and service sectors further eroded.

· Latest Eurosystem projections for 2008 and 2009, due Thursday, likely to show modest downward revision of growth prospects and some upward revision of inflation outlook.

· Financial sector sentiment improves but short-term rates stay high as reduced tensions in money markets offset by expectations that official rate cuts are no longer imminent.

· Additional evidence that past official rate hikes and financial market stress are biting on monetary aggregates, but money and credit growth still uncomfortably high and liquidity overhang goes on widening.

· ECB seen staying in neutral mode, with tightening bias, monitoring how wage negotiations and developments in financial markets, the US economy and global and eurozone growth play out.

· Markets now reflecting EZA's view that official rates likely to remain on hold well into second half of 2008 if not beyond, with a possible rate rise still not ruled out.

© EZA