ECB Vows to Fight Inflation Even as Economy Contracts

By Gabi Thesing

Aug. 14 (Bloomberg) -- The European Central Bank said it will continue to fight inflation even after the economy contracted for the first time since the launch of the euro a decade ago.

``Growth figures for mid-2008 will be substantially weaker than for the first quarter of the year,'' the Frankfurt-based ECB said in its monthly bulletin today. Still, ``against this background and in full accordance with our mandate, the Governing Council emphasizes that maintaining price stability in the medium term is the ECB's primary objective and that it is its strong determination'' to keep inflation expectations anchored.

The ECB raised its key rate to a seven-year high last month to discourage unions from lifting wage demands and companies from increasing prices after inflation accelerated at the fastest pace in 16 years. The economy of the 15 nations sharing the euro contracted in the second quarter from the first, the European Statistics Office said today, as a U.S.-led global slowdown curbed demand for exports and higher oil prices constrained spending.

Gross domestic product fell 0.2 percent from the first quarter, when it rose 0.7 percent. Record oil and food prices kept euro-area inflation to 4 percent in July, twice the ECB's limit.

While oil has retreated 20 percent from a record $147.27 a barrel reached on July 11, inflation risks are ``clearly on the upside and have increased in recent months,'' the ECB said today.

`Pipeline Effect'

The report echoes President Jean-Claude Trichet's comments on Aug. 7 after the bank kept its benchmark rate at 4.25 percent.

``The current monetary policy stance will contribute to achieving the ECB's objective'' of price stability, the report said. Even so, inflation is ``likely to remain well above'' the bank's 2 percent ceiling ``for a protracted period.''

Trichet said last week that ``a pipeline effect'' from commodity-price increases ``is something which is ongoing and undoubtedly creates more risks.'' There is an ``absolute necessity to avoid the materialization of such risks.''

Professional forecasters surveyed quarterly by the ECB have raised their inflation expectations for the next two years and the longer term, the bank said. Inflation will average 3.6 percent this year and 2.6 percent in 2009, the survey showed, up from May forecasts of 3 percent and 2.2 percent respectively.

For 2010, the forecasters estimate an average inflation rate of 2.1 percent. Their longer term inflation estimates have increased to 2 percent from 1.9 percent, according to the report.

Slower Growth

The forecasters predict growth will slow to 1.3 percent next year from 1.6 percent in 2008. They previously expected the economy would expand 1.6 percent in 2009. Growth will pick up to 1.8 percent in 2010, the survey shows.

ECB policy makers remain concerned that faster inflation will prompt companies to pass on their costs and encourage trade unions to demand bigger wage increases to compensate for higher prices.

German negotiated wages jumped 3.5 percent in the year through April, the biggest gain in 12 years, as companies such as BASF AG and ThyssenKrupp AG bowed to union demands.

This year's wage rounds culminate next month, when IG Metall, Germany's biggest union, starts talks for 3.2 million employees in the electronics, metal and car industries whose collective contracts expire Oct. 31. The union won a 5.2 percent raise for about 85,000 steelworkers in February.

To contact the reporter on this story: Gabi Thesing in Frankfurt at gthesing@bloomberg.net.