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ECB to downplay decline in headline inflation

Thu, Sep 4 2008, 07:58 GMT
by KBC Market Research Desk

KBC Bank

• • ECB to leave rates unchanged for the second month in a row
  
• • Threat of second round effects to prevent an early easing in ECB policy rates
  
• • Potential changes of the rules reigning the collateral used in liquidity require attention

At the September ECB policy meeting, the ECB is widely expected to leave rates unchanged at 4.25%. As usual, markets will look out for the ECB press conference for some hints whether recent changes in the growth and inflation outlook have altered ECB thinking on how interest rate policy might evolve in the future.

Over the summer, the euro zone economic outlook has deteriorated sharply and during last month’s press conference, ECB’s Trichet admitted that the ECB was partly surprised by the speed of deterioration, as he said that ‘recent data suggested a materialisation of downside growth risks’. In recent months, financial markets have increasingly focussed on weaker activity and begin to anticipate an eventual turn in ECB policy. However, Mr Trichet and a host of other ECB officials speaking in the past month have continued to stress upside inflation risks and added they had no bias on the future outlook for interest rates.

This month’s introductory statement will include new ECB staff growth and inflation projections for this and next year. Based on recent data, a significant downward revision of the growth projections can be expected from the previous forecasts of 1.8% this year and 1.5% next year. A key question is whether the ECB feels slower growth will alter inflation prospects. In June, the mid-point of the inflation forecasts stood at 3.4% this year and 2.4% next year. Based on the latest Survey of Professional Forecasters, an upward revision of the inflation projections cannot be excluded to around respectively 3.6% and 2.6%. The new ECB staff projections should however be treated carefully, as they will be based upon information available up to the end of August and won’t take into account the latest 10% decline in the oil price.

Since the peak at around 150 USD/barrel, oil prices have dropped to around 105 USD/barrel currently. This will have a huge impact on the headline inflation rate, which has already declined in August from 4.0% Y/Y to 3.8% Y/Y. But despite the expected decline in the headline inflation rate, the ECB is likely to remain concerned about the potential second round effects from past increases in commodity prices mainly via higher wages. The pick-up in the hourly wage growth in Italy in August to the highest level since 1997 for example indicates that some second round effects are occurring.

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Published on  Thu, Sep 4 2008, 08:02 GMT