ECB Signals No Early Rate Change

• High inflation and weak growth put ECB in precarious position
• ECB may still be too optimistic on growth and pessimistic on inflation
• Drop in Euro and equity markets says investors are worried
• Weakening in growth and commodity prices should eventually force the ECB's hand
• But a threatening wage round prevents any early easing
• We expect rates to fall in early 2009 and cumulative drop could be 75 bps if economic growth prospects don't improve

While there was never any serious doubt that the European Central Bank would leave its key policy rate unchanged at 4.25% yesterday, markets were not quite sure what message ECB President Jean Claude Trichet would send in his regular monthly press conference. In recent months, interest rate and currency markets have been very volatile around the monthly ECB press conference as traders attempted to digest some unexpected comments.

There were particular reasons for apprehension before yesterday's press conference. A barrage of unexpectedly weak activity data of late had led traders to anticipate that the ECB will cut rates in the first half of 2009. However, recent comments by several senior ECB official suggested a very different possibility that interest rates might need to be increased further.

Mr. Trichet's comments suggest the ECB is keen to keep its policy options open at present but he also suggested no early change in rates in either direction is likely. In part, this stance reflects some sharply conflicting signs in the current economic climate. We also reckon Mr. Trichet is trying to balance some significant differences of opinion within the ECB's Governing Council on emerging economic trends and the appropriate policy response. Inflation risks are still seen to the upside and there is an understandable concern on the part of the ECB about emerging risks of faster wage growth that might threaten the persistence of high inflation. On the other hand, Mr. Trichet painted an optimistic picture of 'a gradual recovery' in the Eurozone economy after what he described as 'an episode of weak activity' but the tone of yesterday's press conference also suggested some increasing nervousness about downside risks to growth.

Clearly, the ECB is worried about the recent acceleration in wage growth. High profile developments such as the acceleration in Italian wages to their fastest increase in more than 10 years and increasingly trenchant pay demands coming from IG Metall in Germany – seeking increases of 7-8 per cent, hold out the possibility that the current high inflation rate could remain elevated for the foreseeable future. However, important countervailing forces in the shape of weakening economic activity and softening commodity prices hold out the prospect of a notably less threatening trajectory for inflation. In this context, the release yesterday of an unexpected fall in German industrial orders – the eighth consecutive monthly decline, implies rapidly declining scope for Eurozone industry to concede substantial pay increases.

As Diagram 1 above indicates, a weakening trend in orders has been in place since the end of last year. While the exceptional momentum of previous years meant that the German economy continued to register a strong performance until the early summer, the turnaround now emerging seems to be particularly sharp. Judged from this perspective, the relatively modest downgrading of the ECB's growth forecast for 2009 from 1.8% to 1.4% may seem inadequate. Diagram 1 overleaf certainly illustrates why the ECB continues to acknowledge that downside risks prevail but it offers less support for Mr. Trichet's expectation of a trough in growth in the current quarter and a subsequent albeit gradual recovery. In addition this Diagram suggests that oil prices and German industrial orders may be telling the same story of faltering global growth prospects after a period of exceptional increases in recent years. These developments argue that the ECB may be complacent in assuming 'growth in the world economy is expected to remain relatively resilient'.

With a little luck, the easing in commodity prices may also mean the ECB is being too pessimistic in revising up its inflation forecast for 2009 (to 2.6% from 2.4%). In this regard, it is surprising that the first source of upside risks to the outlook listed by the ECB is 'the possibility of renewed increases in commodity prices'. While the ECB is right to be extremely cautious given the extraordinary volatility in energy prices thus far in 2008, it could well be that a less threatening trend will prompt a somewhat earlier improvement in inflation than the ECB now envisages. Provided that wage pressures don't build further in coming months, this could allow the ECB to begin to contemplate cutting interest rates in early 2009. Such a prospect would also appear consistent with Mr. Trichet's assertion that the ECB 'will deliver price stability in 2010'. In summary, Mr. Trichet provided little in the way of fireworks yesterday. In the light of the sharp swings seen after the three previous monthly press conferences, this is no bad thing. That said, it could be argued that the sell-off in the Euro and stock markets as well as the easing in market interest rates is telling us that investors believe the ECB may be underestimating economic growth risks. Admittedly, the ECB is in a difficult position. Scattered signs of unfaltering pressures persist even though the broad 'macro' environment is pointing towards a significant easing in inflation in the next couple of years. High wage demands are a particular problem and with the key German engineering pay round now approaching its noisiest and most threatening period, it makes perfect sense for the ECB to continue to warn of its determination to ensure price stability is attained. However, it is also clear that both the pace of deterioration in Eurozone growth prospects and the fragile condition of a number of Eurozone economies is raising concern at policy level across Europe. We think the irresistible force of softer economic activity will eventually force the 'immovable object' that is the ECB to ease. We think the first rate cut should be delivered by next March and cuts of around 75 bps could be contemplated in the absence of an early improvement in the Eurozone growth outlook.

P.S. ECB collateral changes worry markets

The European Central Bank also announced yesterday the results of a review of the collateral it allows in its liquidity operations. In recent months there have been suggestions that the financial institutions were becoming too dependent on the ECB. As Axel Weber, the head of the Bundesbank put it, the ECB must be thought of as a lender of last resort rather than a lender of first resort and must prevent that the originate to distribute model is replaced by an originate to repo model. Moreover there were some misgivings about the current value of some of the assets used as collateral. While yesterday's changes are relatively modest in 'macro' terms (and extremely complex in detail), at the margin they will have some adverse impact on access to liquidity and make it somewhat more costly, particularly for Special Investment Vehicles (SIVs). Although the measures won't come into force until February 2009, Mr. Trichet said some institutions 'might be forced to bring forward extra collateral'. In nervous markets these measures had a negative impact on already sour sentiment.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.