05 February 2008

EZA 829 Report: ECB Observer

ECB 7 February Council Preview

NO RATE MOVE EXPECTED 7 FEBRUARY: ECB's WAIT-AND-SEE STANCE, WITH TIGHTENING BIAS, SET TO CONTINUE THROUGH TO MID- 2008 AT LEAST.

· Inflation risks reinforced by further rise in 'headline' rate but financial fragility and uncertain GDP growth prospects point to ECB keeping rates on hold, with tightening bias.

· Activity likely to have slowed in 2007 Q4 but money and credit growth still rapid.

· March rate rise now seen as unlikely, odds on summer hike lengthen but no early cut.

EZA continues to take the view that the ECB is unlikely to risk rocking the boat at this juncture by moving its key interest rate despite acute concern about inflationary pressures and question-marks over the continuing resilience of economic growth. We therefore expect the ECB to keep its main refinancing rate unchanged at 4.0% on Thursday while maintaining its tightening bias. It could signal this, as in January, by stressing its readiness to act pre-emptively. In doing so it risks being seen as crying wolf but to use weaker language could be misinterpreted as a shift in its policy stance.

Further ahead, while we expect the Governing Council to maintain its hawkish stance, we now think it unlikely that the ECB will raise rates in March. By then, new GDP figures are likely to show a weakening of growth in the 2007 Q4 and we expect the ECB Staff's March macro projections to show a further downward revision of the growth outlook for 2008. While we still do not rule out a rate rise a few months later, we believe the odds on this have lengthened, given the widening of interest rate differentials that has taken place between the USA (and the UK) and the euro area and the continued appreciation of the euro. On the other hand, barring a crystallisation of the significant downside risks to growth, we do not see the conditions in place by then that would warrant a weakening of the ECB's policy stance.

This view contrasts with the position taken in financial markets. The Euribor futures market has priced in a 25 basis point cut in the ECB's 'refi' rate this summer, with a further 25 basis point cut by the end of the year.

© EZA