Next week's ECB policy meeting is likely to prepare for delicate balancing act.
The level of attention that next week's European Central Bank policy meeting is likely to attract might seem strange given that not one of 83 economists polled by Reuters expects any change to interest rates.
But these are unusual times for central bankers and financial markets, and investors will hang on every word uttered by ECB president Jean-Claude Trichet at the post-meeting press conference. The reason lies in the strong polarisation between the market's view on rates and that of the ECB itself.
Bond yields are pricing in rate cuts from the current 4 per cent in the months to come. But Mr Trichet remains unswervingly committed to fighting inflation, in spite of expectations that eurozone growth is set to slow in tandem with the rest of the global economy. European rates have been held at 4 per cent since last June, even though the US Fed Funds rate has fallen sharply from 5.25 per cent to 3 per cent since September.
A welter of data releases this week highlighted the ECB's dilemma. The "flash" estimate of consumer prices showed that the annual rate of eurozone inflation climbed to 3.2 per cent in January - the highest level since the data series started in 1997 and the fifth successive month that inflation has come in above the ECB's 2 per cent price stability target.
Although a breakdown of the figures is unavailable, it would appear that rising food and energy prices more than offset the dropping-out from the annual comparison of Germany's 3 per cent VAT increase implemented last January.
That view is backed up by an extremely modest decline in German headline inflation rate this month. "If you take into account what should have been significant favourable base effects from last year's VAT hike, the stubbornly high rate of inflation starts to look much more worrying," says Jennifer McKeown at Capital Economics.
Of paramount concern to the ECB will be the risk of second-round inflation effects - particularly given that the eurozone unemployment rate held at a record low of 7.2 per cent in December. The annual 11 per cent wage increase recently secured by German rail workers will no doubt have set alarm bells ringing at the ECB.
But at the same time, overall economic sentiment in the eurozone dipped to its lowest for two years, while consumer confidence - affected by the recent turbulence in financial markets - fell to its worst level since November 2005. And while there was a modest increase in eurozone manufacturing activity last month, there are few analysts who do not expect to see a sharp slowdown in the region's growth as the year wears on.
Indeed, the International Monetary Fund this week slashed its forecast for 2008 growth in the region by half a percentage point to 1.6 per cent. UBS went even further, lowering its forecast to 1.3 per cent. "The bottom line is that we think economic conditions have to get a lot worse before they get better, and that the euro area will feel the fallout from the US recession," says UBS economist Stephane Deo: "Despite our very cautious numbers, we believe the risks to our scenario are still on the downside."
David Brown, chief European economist at Bear Stearns, warns that the European economy is assuming a mantle of stagflation. "Growth momentum is slipping quite sharply while inflation expectations remain on the rise," he says. "The ECB needs to bear in mind that stagflation does not mean the priority must be with inflation. If the dangers to growth are rising, it means that its commitment to counter-cyclical stimulation becomes much more important."
The forthcoming European earnings season might also make for some uncomfortable reading for the ECB. Goldman Sachs thinks the consensus expectation for 10 per cent European earnings growth this year is far too high.
"Our top-down model suggests European profits will fall by 8 per cent this year as the US enters a recession, global growth slows and high costs begin to erode corporate profitability in the face of slowing revenues," says strategist Georgina Taylor. "We also expect a decline in profit margins - consensus continues to expect margin expansion across the majority of sectors."
For all that, one could be forgiven for thinking that the next rate move could be upwards given recent comments from ECB board members. For example, the head of the Greek central bank has stressed that if there was a risk the ECB would not achieve its inflation objective in the medium-term, it would be prepared to act decisively and pre-emptively.
Such remarks add weight to the view that the ECB is walking a very tricky policy tightrope at the moment. As Mr Brown at Bear Stearns notes: "The price that the ECB paid for delaying the easing cycle in 2001 was a German recession and interest rates ultimately had to come down to 2 per cent."
The level of attention that next week's European Central Bank policy meeting is likely to attract might seem strange given that not one of 83 economists polled by Reuters expects any change to interest rates.
But these are unusual times for central bankers and financial markets, and investors will hang on every word uttered by ECB president Jean-Claude Trichet at the post-meeting press conference. The reason lies in the strong polarisation between the market's view on rates and that of the ECB itself.
Bond yields are pricing in rate cuts from the current 4 per cent in the months to come. But Mr Trichet remains unswervingly committed to fighting inflation, in spite of expectations that eurozone growth is set to slow in tandem with the rest of the global economy. European rates have been held at 4 per cent since last June, even though the US Fed Funds rate has fallen sharply from 5.25 per cent to 3 per cent since September.
A welter of data releases this week highlighted the ECB's dilemma. The "flash" estimate of consumer prices showed that the annual rate of eurozone inflation climbed to 3.2 per cent in January - the highest level since the data series started in 1997 and the fifth successive month that inflation has come in above the ECB's 2 per cent price stability target.
Although a breakdown of the figures is unavailable, it would appear that rising food and energy prices more than offset the dropping-out from the annual comparison of Germany's 3 per cent VAT increase implemented last January.
That view is backed up by an extremely modest decline in German headline inflation rate this month. "If you take into account what should have been significant favourable base effects from last year's VAT hike, the stubbornly high rate of inflation starts to look much more worrying," says Jennifer McKeown at Capital Economics.
Of paramount concern to the ECB will be the risk of second-round inflation effects - particularly given that the eurozone unemployment rate held at a record low of 7.2 per cent in December. The annual 11 per cent wage increase recently secured by German rail workers will no doubt have set alarm bells ringing at the ECB.
But at the same time, overall economic sentiment in the eurozone dipped to its lowest for two years, while consumer confidence - affected by the recent turbulence in financial markets - fell to its worst level since November 2005. And while there was a modest increase in eurozone manufacturing activity last month, there are few analysts who do not expect to see a sharp slowdown in the region's growth as the year wears on.
Indeed, the International Monetary Fund this week slashed its forecast for 2008 growth in the region by half a percentage point to 1.6 per cent. UBS went even further, lowering its forecast to 1.3 per cent. "The bottom line is that we think economic conditions have to get a lot worse before they get better, and that the euro area will feel the fallout from the US recession," says UBS economist Stephane Deo: "Despite our very cautious numbers, we believe the risks to our scenario are still on the downside."
David Brown, chief European economist at Bear Stearns, warns that the European economy is assuming a mantle of stagflation. "Growth momentum is slipping quite sharply while inflation expectations remain on the rise," he says. "The ECB needs to bear in mind that stagflation does not mean the priority must be with inflation. If the dangers to growth are rising, it means that its commitment to counter-cyclical stimulation becomes much more important."
The forthcoming European earnings season might also make for some uncomfortable reading for the ECB. Goldman Sachs thinks the consensus expectation for 10 per cent European earnings growth this year is far too high.
"Our top-down model suggests European profits will fall by 8 per cent this year as the US enters a recession, global growth slows and high costs begin to erode corporate profitability in the face of slowing revenues," says strategist Georgina Taylor. "We also expect a decline in profit margins - consensus continues to expect margin expansion across the majority of sectors."
For all that, one could be forgiven for thinking that the next rate move could be upwards given recent comments from ECB board members. For example, the head of the Greek central bank has stressed that if there was a risk the ECB would not achieve its inflation objective in the medium-term, it would be prepared to act decisively and pre-emptively.
Such remarks add weight to the view that the ECB is walking a very tricky policy tightrope at the moment. As Mr Brown at Bear Stearns notes: "The price that the ECB paid for delaying the easing cycle in 2001 was a German recession and interest rates ultimately had to come down to 2 per cent."
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