ECB May Leave Key Rate at Seven-Year High to Fight Inflation

By Simone Meier

Sept. 4 (Bloomberg) -- The European Central Bank will keep interest rates at a seven-year high to fight inflation even as the euro-region economy teeters on the brink of a recession, a survey of economists shows.

ECB policy makers meeting in Frankfurt will leave the benchmark lending rate at 4.25 percent, according to all but one of 53 economists in a Bloomberg News survey. The bank will wait until at least March next year to lower borrowing costs, another survey shows.

The ECB wants to prevent a wage-price spiral as workers demand compensation for higher food and energy costs. It raised rates in July and council members Axel Weber and Lucas Papademos said last week another increase may be necessary if inflation risks increase. At the same time, the economy contracted in the second quarter and inflation slowed after oil prices retreated from a record.

``We remain skeptical that slowing growth and retreating oil prices will open the door for rate cuts,'' said Nick Kounis, chief European economist at Fortis Bank in Amsterdam. ``The concerns about inflation are very real.''

The ECB will announce its decision at 1:45 p.m. and President Jean-Claude Trichet holds a press conference 45 minutes later. In addition to commenting on monetary policy, Trichet may announce changes to the ECB's collateral requirements for lending to banks.

Separately, the Bank of England will probably keep its key rate at 5 percent, a Bloomberg survey shows.

Wage Threat

While crude oil prices have retreated 26 percent from a record $147.27 a barrel on July 11, they're still up 46 percent over the past year. Euro-region inflation slowed to 3.8 percent in August from a 16-year high of 4 percent in July. The ECB aims to keep the rate below 2 percent.

Some labor unions are already pushing through bigger wage increases to compensate workers for the higher cost of living. Deutsche Lufthansa AG, Europe's second-largest airline, last month agreed to a 5.1 percent raise for some ground staff and cabin crew after a strike forced the cancellation of hundreds of flights.

IG Metall, Germany's biggest union, starts wage negotiations this month for 3.2 million metal, electronics and car workers. The union has said it will demand a bigger pay increase than the 6.5 percent it asked for last year.

ECB Vice President Papademos on Aug. 27 said the emergence of a wage-price spiral would ``require a stronger degree of monetary tightening.''

New Forecasts

While the ECB will raise its inflation estimates when it publishes new economic projections today, it will lower its outlook for growth, said Laurent Bilke, an economist at Lehman Brothers in London who used to work as a forecaster at the central bank. He predicts the ECB will be forced to cut rates in January.

In June, the bank forecast growth of about 1.8 percent this year and 1.5 percent in 2009. It projected inflation would average 3.4 percent this year and 2.4 percent next year.

Since then, Europeans' confidence in the economic outlook plunged to a five-year low and the manufacturing and service industries contracted for a third consecutive month, indicating the economy may have entered a recession.

``The possibility of a rate hike by the end of the year has vanished,'' said Bilke. ``The situation has already deteriorated enough for a single rate cut to be insufficient.''

Investors are less certain and have scaled back bets on lower ECB rates, Eonia forward contracts show. The yield on the May contract was at 4.10 percent yesterday, up from 4.03 percent before Papademos and Weber spoke.

Speculation `Premature'

In an interview published Aug. 27, Bundesbank President Weber said ``the discussion about declining rates in Europe is premature.'' The ECB may have to raise rates further ``if the economic outlook brightens,'' he said.

The euro's 9 percent decline from its peak of $1.60 on July 15 may help to bolster European exports, while lower oil prices should eventually leave consumers with more money to spend.

The ECB ``is not yet persuaded that growth will be weak enough over the next 18 months to more than outweigh second-round effects stemming from prior increases in commodity prices,'' David Mackie, chief European economist at JPMorgan in London, wrote in a research note to clients. ``It will take a while for the central bank to come around to the idea of easing.''

To contact the reporter on this story: Simone Meier in Frankfurt at smeier@bloomberg.net