ECB's Bonello Sees Economy Past Worst by Year-End

By Gabi Thesing and Blanche Gatt

Sept. 24 (Bloomberg) -- European Central Bank Governing Council member Michael Bonello said the euro region's economy will probably recover in the fourth quarter, suggesting he sees no need to lower interest rates after the global credit squeeze worsened.

``I still think by the fourth quarter we should be out of the lowest point, at least past the trough,'' Bonello, who also heads the central bank of Malta, said in an interview in his office in Valletta yesterday. ``Monetary policy cannot fix'' the financial system and inflation risks are ``all on the upside,'' he said.

Business confidence in the euro area's three largest economies fell this month more than economists forecast as financial turmoil in the U.S. imperiled growth around the world, industry surveys showed today. The ECB has so far said slowing growth isn't enough to overcome concern that the fastest inflation in 16 years will become entrenched through a wage-price spiral.

In the past two weeks, Lehman Brothers Holdings Inc. collapsed and the U.S. government took over American International Group Inc. The world's biggest financial companies have posted more than $520 billion in writedowns and credit losses since the start of last year after record defaults on housing loans to consumers with poor credit histories, pushing up borrowing costs as banks became reluctant to lend to each other.

No Silver Lining

An economic slump in the U.S. risks dragging the world economy down by hurting exports. Growth in China and Germany, Europe's biggest economy, has been driven by sales abroad. Some say the ECB needs to start considering rate cuts.

``We don't see a silver lining in the fourth quarter,'' Gernot Nerb, an economist at the Munich-based Ifo institute, said in a Bloomberg Television interview today. ``The time has come to lower interest rates. That doesn't have to happen next week, but the signal should soon come that rates will fall in the next few months.'' Ifo carries out the German executive sentiment survey.

Bonello, 63, didn't rule out that the economy may shrink again in the current quarter.

``The difference between no growth, which is what people were expecting, and slightly negative growth isn't that great,'' he said. ``The world economy is not going into freefall.''

The policy maker said the fact that last week's German ZEW investor confidence index ``didn't deteriorate further in the midst of all this negative news I think points to a certain degree of resilience to the setbacks which the current turmoil would imply.'' The ZEW index rose more than expected last week as the retreat in oil prices and the euro improved the economic outlook.

Delayed Recovery?

``I think the ECB shouldn't be so relaxed'' in the light of recent data, said Kenneth Broux, an economist at Lloyds TSB Group Plc in London. ``The numbers suggest the slowdown might be more protracted and the recovery might be delayed.''

Germany's Ifo business sentiment indicator declined to the lowest level in three years, French business confidence slumped to a five-year low and Italian executives were the most pessimistic in seven years.

In the U.S., Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are cajoling lawmakers to back a $700 billion proposal to use public funds to buy devalued mortgage investments.

Economists at Citigroup Inc. and Societe Generale now forecast that inflation may fall back to below 2 percent as soon as next year as slowing growth keeps a lid on price gains.

Bonello isn't convinced.

Inflation Pressure

``There is no mechanical trade-off between growth and inflation,'' Bonello said. ``Inflation falling below 2 percent next year cannot be excluded, but only if oil prices stabilize and if we don't have any further negative surprises. Given the many sources of upside pressures I feel more confident in saying that inflation should drop toward the 2 percent threshold in 2010.''

Throughout the turmoil the ECB has kept interest rates at a seven-year high. Rebuffing calls from investors to lower borrowing costs, the ECB instead poured cash into the financial system to facilitate lending among commercial banks.

``It's an immediate problem we have today, monetary policy works in the medium term,'' Bonello said. ``Central banks' primary role is to secure price stability.''

Economists expect the ECB to keep rates on hold until February 2009, according to the median of 21 forecasts in a Bloomberg News survey published yesterday.

Wage Demands

The bank raised its key rate to 4.25 percent in July after record oil prices pushed inflation to 4 percent. Policy makers are concerned that workers will try to compensate for the increase in the cost of living by boosting wage demands. Companies may also seek to raise prices to offset higher raw-material and wage costs.

Even though inflation eased to 3.8 percent in August, it's ``still well above'' the bank's 2 percent limit, Bonello said.

Germany's IG Metall labor union, representing 3.2 million workers, yesterday said it wants wages to rise 8 percent next year. It would be the biggest pay increase in 16 years. The five- year/five-year forward breakeven rate, the ECB's key gauge of medium-term inflation expectations, yesterday rose to 2.69 percent, 1 basis point short of the record high it reached August.

For now, ``it's not the cost of money that is perhaps at the forefront of people's concerns,'' Bonello said. ``The effort worldwide to calm things down in the financial markets, I think that is certainly the priority.''

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