ECB Hawkish But Softening Around the Edges

For the second month in a row, the ECB left rates unchanged at 4.25%. The predominant concern of the Governing Council (GC) remains the risk that past sharp increases in food and energy prices, and their ongoing elevated levels, could feed through into higher general prices and wages throughout the Eurozone. As such, the ECB staff's inflation forecasts for 2008 and 2009 were nudged higher in spite of lower expectations for GDP growth in both years. At the same time, the ECB announced some changes to measures put in place to deal with the credit crunch, which will take effect in February 2009 and tighten up some of the lending standards.

However, for the second month in a row, while the Governing Council's window is clearly looking out on ongoing upside risks to inflation, the window dressings around that view seem to be moving towards something more pleasant. Rather than noting “increasing upside risks to price stability” as was mentioned in August, this month those risks remain to the upside, but are not said to be increasing. This nuance appears to have been sprinkled into the concerns of second round effects, as well, as the risk is now for “stronger” rather than “increasing indirect effects on consumer prices.”

The ECB staff lowered their GDP growth forecasts for 2008 from a range of 1.5-2.1% to a range of 1.1-1.7%, and lowered the 2009 forecast from a range of 1.0-2.0% to a range of 0.6-1.8%. The staff's forecast for inflation for 2008 changed only slightly, increasing from a range of 3.2-3.6% to a range of 3.4-3.6%, while the forecast for 2009 firmed up a bit from the June forecast of a range of 1.8- 3.0% to one of 2.3-2.9% in the September forecast. The more important change in our opinion is that the upper inflation bound did not increase. It is also important to distinguish between average annual inflation rates and the path the year-over-year rate of inflation will likely see. We continue to expect the inflation rate to dip below 2.0% in the first half of 2009, which would still be consistent with President Trichet's comments today that the GC's current expectation is a return to price stability in 2010.

Lastly, the ECB's assessment of credit growth was further downgraded this month, as the ECB acknowledged that corporate demand for credit growth is slowing with loans to the nonfinancial corporate sector easing from 13.6% to 13.2% in August. While the level remains too high for the ECB's liking, in our opinion, the cooling trend seems likely to continue and will be the driving factor in determining when the ECB may feel comfortable in easing rates. Early economic data for the third quarter suggest nearly flat GDP growth and not the modest bounce that was anticipated by the ECB following the volatile first half of 2008. Coupled with our expectation for oil prices to continue to moderate slightly, we still expect an ECB easing cycle to begin with a quarter-point cut in March 2009 followed by a second in May 2009.

TD Bank Financial Group

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