Trichet May Resist Rate Cut as Inflation Spiral Looms

By Christian Vits

Aug. 13 (Bloomberg) -- European Central Bank President Jean- Claude Trichet may look beyond a likely contraction in the euro region's economy and keep interest rates at a seven-year high to avert a wage-price spiral.

Investors who seized on Trichet's Aug. 7 comments that growth will be ``substantially weaker'' and raised bets that the next step will be an easing missed the point, said Andreas Scheuerle, an economist at Dekabank in Frankfurt.

The reaction to the remarks, which drove the euro down almost seven cents against the dollar, overshadowed Trichet's warning minutes later that his priority is preventing the fastest inflation in 16 years from becoming entrenched.

``Market expectations that the next move will be a cut are premature,'' said Juergen Michels, an economist at Citigroup Inc. in London. ``When it comes to the crunch, the ECB will sacrifice growth to fight inflation.''

Record oil and food costs pushed euro-region inflation to 4.1 percent in July, double the ECB's 2 percent limit. The Frankfurt- based central bank kept its key rate at 4.25 percent last week after raising borrowing costs in July.

While oil prices have retreated 20 percent from a record $147.27 a barrel reached on July 11, inflation may not slow as quickly as investors hope, said Leo Doyle, an economist at Dresdner Kleinwort in London.

`Pipeline Effect'

``The speed of inflation's decline could still disappoint the markets,'' said Doyle. Domestic heating costs ``are likely to continue rising for another six months at least,'' meaning inflation may remain above 3 percent well into next year.

Trichet said last week that ``a pipeline effect'' stemming 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,'' he said at the press conference following the rate decision.

Lower oil prices may also bolster economic growth, lending weight to workers' demands for more pay to compensate for the higher cost of living. ECB policy makers are concerned a wage- price spiral will develop as companies raise prices to cover increased labor costs.

``Trichet can't say he'll fight inflation and then do nothing,'' said Axel Botte, a Paris-based fixed income strategist at Axa Investment Managers which has about $800 billion in assets under management. ``There is still a possibility the ECB may hike and the markets are unprepared for that.''

Response to Trichet

Yields on Eonia forward contracts, a widely used market gauge of interest-rate expectations, plunged after Trichet said growth risks are materializing and the ECB has ``no bias'' on future rates. The yield on the March contract fell to 4.14 percent from 4.35 percent. The euro has dropped as low as $1.4816 since Trichet's press conference from $1.5503 beforehand.

``The economic outlook is deteriorating at such a rate that the ECB will have to cut rates eventually,'' said Stuart Thomson, a money manager at Resolution Investment Management Ltd. in Glasgow, which oversees about $46 billion in bonds.

Trichet's acknowledgement that the growth outlook has deteriorated ``reinforced investors' views that the U.S. economy is a better bet at this stage,'' Thomson said.

JPMorgan Chase & Co. today predicted the ECB will cut its benchmark rate three times next year to 3.5 percent, starting in the first quarter. JPMorgan previously forecast the ECB would keep borrowing costs on hold through 2009.

GDP Preview

The 15-nation euro-region economy probably contracted 0.2 percent in the second quarter from the first, according to a Bloomberg News survey of economists. The European Union's statistics office in Luxembourg will publish its initial estimate of second-quarter gross domestic product at 11 a.m. tomorrow.

By contrast, the U.S. economy expanded 0.5 percent in the three months through June after the Federal Reserve slashed its key rate to 2 percent from 5.25 percent.

Trichet is unlikely to follow suit as he remains focused on battling inflation and says that economic fundamentals in the euro region remain ``sound.''

Furthermore, ``if the decline in oil prices persists we'll see a positive impact'' on economic growth, said Holger Sandte, chief European economist at WestLB Equity Markets in Dusseldorf. ``A better economic outlook would be grist to the mill for the unions.''

Negotiated wages in Germany, Europe's largest economy, 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.

Wage inflation in Italy accelerated to 3.6 percent in June, the fastest in three years, even as the Italian economy contracted 0.3 percent in the second quarter.

There is ``a very strong concern that price and wage-setting behavior could add to inflationary pressures,'' Trichet said last week. While growth is weakening, the ECB has ``only one needle'' in its compass and ``that needle is price stability.''

To contact the reporter on this story: Christian Vits in Frankfurt at cvits@bloomberg.net