Weber Says Higher Rates May Be Needed After Recovery

By Christian Vits and Andreas Scholz

Aug. 27 (Bloomberg) -- European Central Bank council member Axel Weber said there's no scope for interest-rate cuts and policy makers may need to raise borrowing costs once the economy emerges from its slump.

``Monetary policy at the moment is roughly where it should be and I think the discussion about declining rates in Europe is premature,'' Weber, 51, said in an interview in his office in Frankfurt yesterday. ``If the economic outlook brightens somewhat again towards the end of the year and next year, which I still expect, we'll have to see if action is necessary.''

Europe's economy contracted in the second quarter and may not recover in the third, raising the risk of the region's first recession since the euro was introduced in 1999. Weber said the ECB, which increased its benchmark rate by a quarter point to 4.25 percent in July, remains focused on fighting inflation. Bond yields and the euro jumped.

``I don't expect inflation to come down necessarily just with weaker growth,'' Weber said. ``Inflation is still the No. 1 worry for central bankers in the euro region.''

``Weber wants to keep the option open to raise rates next year,'' said Holger Schmieding, chief European economist at Bank of America Corp. in London. ``He wants to choke any rate-cut debate.''

Rate-Cut Bets

This morning, Eonia forward contracts showed investors had fully priced in a cut in the ECB's benchmark rate to 4 percent by May. The yield on the May contract rose 9 basis points to 4.09 percent after Weber's remarks were published. The euro gained half a cent to $1.4773 and yields on two-year government bonds increased 4 basis points to 4.03 percent.

Weber said while current rates are ``roughly adequate'' for ``the imminent period of cyclical weakness,'' they are ``still more on the accommodative side than being neutral.''

Inflation at 4 percent is running at twice the ECB's definition of price stability of just less than 2 percent.

Inflation will remain in breach of the ECB's price-stability goal next year and ``we're not even sure that inflation on average will be below 2 percent in 2010,'' Weber said.

``If inflation risks further materialize and if we come to the conclusion that the inflation outlook has deteriorated, we'll have to re-examine our monetary-policy stance,'' he said.

Recession Concern

``His views will not be shared across the ECB Governing Council,'' said Ken Wattret, an economist at BNP Paribas SA in London. ``Keeping a consensus opinion together in this environment is going to be quite a challenge for'' ECB President Jean-Claude Trichet.

Business confidence in Germany plunged to a three-year low this month, heightening concern that Europe's largest economy is slipping into a recession.

While oil prices have receded from a record $147.27 a barrel, they're still up more than 60 percent over the past year, crimping companies' spending power just as the euro's appreciation and the U.S. housing slump weigh on exports.

In June, ECB staff projected growth would slow to about 1.8 percent this year and 1.5 percent in 2009 from 2.7 percent in 2007. The bank will publish new growth and inflation forecasts on Sept. 4, when it announces its next rate decision.

Weber said he expects ``a slight downward correction'' of the growth estimates for this year and next. ``The European economy, in my opinion, will be robust once we're through this dry spell,'' he said.

Inflation Expectations

Inflation forecasts may be revised ``slightly higher'' from the current 3.4 percent and 2.4 percent for this year and next. The ECB is concerned that long-term inflation expectations are above 2 percent, Weber said.

The long-term inflation expectation, defined as through 2013, rose to 2.03 percent in August, according to the ECB's quarterly survey of forecasters published Aug. 14. That's the highest since the survey started in 1999 and up from 1.95 percent three months ago. Expectations measured by the breakeven rate on French five- year inflation-indexed bonds were at 2.19 percent today.

``We observe with concern that the majority of market watchers don't expect us to meet our stability norm at the 6 to 10-year horizon,'' Weber said. ``For a central bank this puts in question its credibility and this can't be tolerated.''

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