ECB May Keep Rates at 7-Year High as Recession Looms

By Gabi Thesing

Sept. 1 (Bloomberg) -- The European Central Bank will probably keep interest rates at a seven-year high this week, and may even threaten to raise them, at the risk of prolonging the economic slump.

All but one of 47 economists surveyed by Bloomberg News predict the Frankfurt-based central bank will leave the benchmark rate at 4.25 percent on Sept. 4 and only five expect a cut this year, even after the region's economy contracted in the second quarter.

``Rates at this level are certainly not helping the economy and there is a risk of a recession, but the ECB wants to address the problem of inflation first,'' said Stephane Deo, chief European Economist at UBS AG in London. ``Only when inflation returns to more comfortable levels will it consider easing policy.''

Policy makers Axel Weber and Lucas Papademos said last week the ECB remains focused on inflation risks and may need to lift rates again if they intensify. Executive Board members Lorenzo Bini Smaghi and Juergen Stark also stepped up their inflation- fighting rhetoric, just days before they meet to decide on rates.

``The comments were a wake-up call to the markets, which had gotten ahead of themselves in light of dire economic data,'' said Ulrich Katz, a Munich-based portfolio manager at Pacific Investment Management Co. which has over $800 billion under management. Investors ``assumed the ECB would soften its inflation-fighting stance. Well, it clearly hasn't.''

Rate-Cut Bets

Some investors started betting on a rate cut by early next year after ECB President Jean-Claude Trichet said on Aug. 7 that economic growth would be ``particularly weak'' through the third quarter. Last week, a rate reduction was fully priced in by May, Eonia swap contracts showed. The yield jumped back up to 4.13 percent after Weber and Papademos spoke.

``The discussion about declining rates in Europe is premature,'' Weber said in an interview published Aug. 27. ``I don't expect inflation to come down necessarily just with weaker growth. Inflation is still the No. 1 worry for central bankers in the euro region.''

The ECB raised rates in July to prevent a wage-price spiral after inflation accelerated to 4 percent, twice its 2 percent limit. Since then, data showed Europe's economy contracted 0.2 percent in the second quarter and economic confidence has plunged. At the same time, a 20 percent drop in oil prices has slowed inflation to 3.8 percent.

`Wrong to Hike'

``The ECB is defending its July rate increase,'' said Laurent Bilke, an economist at Lehman Brothers International in London who used to work as a forecaster at the ECB. ``To admit two months after a rate increase that inflation pressures are easing would mean they were wrong to hike. The bank is confronted with a recession and will start to cut in January.''

Trichet will on Sept. 4 unveil new economic forecasts that are likely to revise down the growth assessment and ratchet up the outlook for inflation, said Elga Bartsch, an economist at Morgan Stanley in London.

``If you only have one needle in the compass, which in the ECB's case is inflation, then you'll have to toughen your language,'' Bartsch said. The ECB is more likely to raise rates than cut them, she said.

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. Inflation was forecast to average 3.4 percent this year and 2.4 percent in 2009.

`Too High'

``Inflation is still high, too high,'' Bini Smaghi told Bloomberg Television on Aug. 28. ``We have a 2 percent target and we must bring it back to 2 percent -- below 2 percent,'' he said, adding its only tool to do so is interest rates.

Should inflation risks materialize, ``we'll have to re- examine our monetary-policy stance,'' Weber said. Papademos warned that the emergence of a wage-price spiral would ``require a stronger degree of monetary tightening.''

Wage inflation is accelerating across Europe as workers seek compensation for higher food and energy costs. IG Metall, Germany's biggest union whose wage accords cover 3.2 million workers, will present this year's claim on Sept. 8. It has said it will demand a bigger pay increase than the 6.5 percent it asked for last year.

The ECB is ``throwing down the gauntlet to IG Metall,'' said Natacha Valla, Goldman Sachs' chief French economist who was previously a forecaster at the ECB. The fact that ``a discreet member like Papademos was so explicit about wage growth possibly requiring further tightening shows how central wage negotiations are to the inflation debate.''

Even so, the ECB won't follow through on its threat, said Stefan Bielmeier, an economist at Deutsche Bank AG in Frankfurt. Deutsche Bank expects a rate reduction in the first quarter of 2009.

``The ECB won't cut rates before inflation is under control,'' Bielmeier said. ``But with the economy tanking, it won't need to hike again.''

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