ECB MASTERFUL INACTIVITY CONTINUES
Lombard Street Research
18 years of forecasting success
by Gabriel Stein
January 10, 2008

WE SUGGEST: No ECB rate cut in H1 2008 (possibly longer)

SUMMARY: Perhaps surprisingly, the ECB Governing Council only discussed two options today � leaving interest rates unchanged or raising them! But given that the Bank has raised its inflation forecast, while growth is still forecast to be on trend, this was a natural discussion. It almost certainly means no interest rate cut at all in 2008 � and a hike if wage settlements cement higher inflation.

As expected, the ECB did not change interest rates today. But there were still one or two surprises in M. Trichet�s press conference. First, while he reiterated the Bank�s oftexpressed warning against letting temporary inflation become entrenched through higher wage settlements leading to spiralling inflation expectations and pressures � his warning that the ECB is ready to act pre-emptively against rising inflation was unusually robust. In response to a question, M. Trichet made it clear that the Governing Board had, in fact, only discussed two options: leaving interest rates unchanged � or raising them!

This fits in well with the Bank�s changing inflation forecast � the second surprise.. Where previously inflation was forecast to ease back below 2% in 2008. Now, inflation is forecast to remain �significantly above� 2% in coming months and then only �moderate gradually� thereafter. Translation: Inflation will remain higher for longer. Minimum bid rate Marginal lending facility 3-month euro euribor

A third surprising statement was that the ECB so far has not seen much effect of financial market turmoil on credit and money growth data. Given that both broad money and credit growth remain by any stretch of imagination excessive, this would further strengthen the ECB�s view that interest rates should not be cut.

Of course, where there has been an effect is on money market interest rates. However, following the large-scale liquidity injections over the holiday season (and M. Trichet also announced that the ECB is continuing to offer dollar facilities in January and possibly later on in the year as well) market interest rates have steadily come down. They remain elevated by historic standards � but they are well down from their peaks of late 2007. This would help to explain why the ECB sees no particular need to ease monetary policy right now.

Euroland output growth for Q3 was revised from 0.7% to 0.8%. At the moment, there is no Euroland output gap (or only a very small one). With output still likely to grow close to trend in 2008, inflation above target and broad money growth close to three times the ECB�s medium-term reference value, the ECB is clearly doing the right thing. The message of today's decision and press conference is clearly that interest rates are not going to be cut, not now, probably not for the next six months and � absent a sharper than expected slowdown in the United States and the Far East � probably not at all in 2008.

© 2008 Gabriel Stein
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Gabriel Stein
Director and Chief International Economist
Lombard Street Research
United Kingdom
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