ECB Holds Rates Steady, but Growth Concerns are Beginning to Supplant Fears About Inflation

By Jason Simpkins
Associate Editor

After boosting its benchmark interest rate by a quarter point on July 3, the European Central Bank (ECB) may be forced to reverse course and cut rates sooner than it planned, as slow growth is beginning to trump concerns about inflation.

The ECB left its key rate unchanged at 4.25% yesterday (Thursday). ECB President Jean-Claude Trichet said that while growth will be "particularly weak" in the second and third quarters, inflation is also "likely to remain well above levels consistent with price stability for a protracted period of time."

"Risks to price stability over the medium term remain on the upside," he added, noting that recent data "underpinned" the bank's decision to raise rates last month.

However, don't anticipate the ECB will have the wiggle room to raise rates any higher, as more and more data suggests the European Union is entering a recession.

An unexpected drop in Germany's factory orders for June was the latest blow to the Eurozone's economic outlook. Orders fell 2.9% in June, after a 1.4% decline in May, leading economists to speculate that economic growth in Europe's largest economy is contracting.

The German economy contracted by 1% in the second quarter, and Eurozone growth may was flat at best, economists at BNP Paribas SA (OTC: BNPQY) said in a research note.

"In light of the imploding order flow, the July ECB rate hike looks increasingly like a policy mistake in need of being urgently reversed," MarketWatch quoted the note as saying. 

However, it could be awhile before the ECB changes its direction. Inflation remains at a 16-year high after consumer prices soared 4.1% in July. And according to Trichet, "there are some indications that labor-cost growth has been rising in recent quarters."

Negotiated wages in Germany were up 3.5% in the year through April, the biggest gain in 12 years, according to Bloomberg News. In Italy, wage inflation jumped to 3.6% in June.

Inflation risks "remain clearly on the upside and have increased over the past few months," Trichet said. "There is very strong concern that price and wage-setting behavior could add to inflationary pressure."

It's possible the ECB may start cutting rates in early 2009, if not late this year. However, economists aren't holding their breath.

"They are a bit of an oil tanker. They don't change course very rapidly," Russell Jones, head of fixed income and currency strategy research at RBC Capital Markets Corp., told MarketWatch.

Another analysts, Matthew Sharratt, an economist at Bank of America in London (BAC), told Bloomberg that "they'restill focused on high inflation, but the best way to avoid a policy mistake would be to keep interest rates on hold."

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