ECB: "Downside Risks Have Materialised"

Overview: After the recent sharp deterioration of activity data, it was never a question of if, but when the ECB would have to soften its tone on the growth outlook. Many had expected it to happen at the September meeting, as ECB is due to present new projections at that meeting, but instead it happened one month earlier. The ECB has now made the first move from a tightening bias to a completely neutral stance. The market responded quickly - predicting that the ECB's next move would be towards an easing bias - and priced in a rate cut by mid- 09. Our forecast is for the ECB to be on hold on a 12M horizon, but the pendulum has swung back towards a rising probability of policy easing next year. We believe the market will price more cuts as activity and unemployment deteriorate further during autumn, which points to a further decline in bond yields.

Details: The ECB made significant changes in its growth section. The central bank now says "growth figures for mid-2008 will be substantially weaker than for the first quarter of the year" - a change from expecting growth in the second quarter to be "rather weak". In previous statements, the ECB concluded the growth section with "… information available remains broadly in line with our expectation of moderate ongoing growth". This phrase was left out this time, and the bank no longer concludes on the growth outlook - a clear hint that the outlook has changed, but that the ECB will wait for the staff projections next month to give a more precise description. The world economy is now seen as "relatively resilient" instead of just "resilient". An acknowledgement of the weaker data from Emerging Markets, where the central bank now sees "sustained growth" instead of "continued robust growth"

In the inflation section, not much was changed; hence the ECB maintained a quite hawkish tone. Interestingly, the central bank kept the phrase: "Risks to price stability at the policy-relevant medium-term horizon remain clearly on the upside and have increased further over the past few months". Given the drop in oil prices recently, it is noteworthy that the ECB still refers to the past few months. But the central bank was probably afraid to remove this phrase, as the bank did not want the market to interpret it as being too dovish. The monetary pillar also was broadly the same, as the ECB again concluded that the "monetary analysis confirms the prevailing upside risks to price stability at medium to longer-term horizons" and said again that "over recent quarters, these risks appear to have become manifest as inflation has trended upwards". It is a bit interesting that the bank links the rise in inflation this year to monetary developments, hence indirectly linking Euroland high money growth to the rising commodity prices - since that is where inflation is showing up in the data.

Assessment and outlook: A clear softening of the growth section indicates that the ECB is now at a completely neutral stance. We believe the real trigger for the shift in the ECB's assessment has been the rapid drop in the German ifo indicator and other German data. Germany has gone from "last man standing" to "last man falling", and there are no longer any pillars of growth left in Euroland to stand on. This goes to show how important Germany - and the ifo indicator - is for sentiment on the Euroland economy. We continue to believe the ECB will stay on hold on a 12M horizon, but risks of a cut next year have increased.

Danske Bank

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