ECB's Papademos Says Europe Likely to Avoid Recession

By Simone Meier and Gabi Thesing

Sept. 11 (Bloomberg) -- European Central Bank Vice President Lucas Papademos said the economy is likely to escape a recession and there are signs higher energy costs are driving up wages on a broad front.

``There are indications that broad-based second-round effects are materializing and we want to make sure that they don't become even broader and stronger,'' Papademos told reporters in Hamburg today. ``It's not considered likely'' that the euro-area economy will shrink in the third quarter ``but it can't be excluded, taking into account uncertainty and downside risks,'' he added.

The 15-nation economy contracted in the second quarter and is struggling to recover in the third. The ECB nevertheless raised interest rates to a seven-year high in July and said it will act to ensure that faster inflation doesn't become entrenched as workers seek compensation for higher food and energy costs.

``It's essential that broader-based second-round effects are avoided,'' Papademos said today. His comments were echoed by ECB council member Yves Mersch, who said slower economic growth and a drop in oil prices have not blunted inflation risks.

``While oil prices have declined, past increases could still trigger a wage-price spiral,'' Mersch said in the bi-annual economic bulletin of the Luxembourg central bank, which he heads. The inflation risks identified when the ECB raised its key interest rate to 4.25 percent in July ``remain today.''

Wage Demands

Inflation is running at 3.8 percent, almost twice the ECB's 2 percent limit.

IG Metall, Germany's biggest labor union representing 3.5 million workers, said Sept. 8 it will seek a pay increase of between 7 percent and 8 percent when wage negotiations start on Oct. 2. That would be the biggest wage increase in at least 16 years. Workers at Ireland's Electricity Supply Board are demanding an 11.25 percent raise.

``Papademos and Mersch are just pragmatic,'' said Kenneth Broux, an economist at Lloyds TSB Group Plc in London. ``The ECB is confident that growth will recover in the fourth quarter and unless they see data to the contrary, they will not ease policy.''

The euro-area economy shrank 0.2 percent in the three months through June. Manufacturing orders in Germany, Europe's largest economy, fell for an unprecedented eighth straight month in July and Europe's manufacturing and service industries contracted for a third month in August.

Recession Risk

A third-quarter decline in gross domestic product would put the 15-nation euro-region economy into its first recession since the launch of the single currency in 1999.

The European Commission yesterday predicted the economy will stagnate this quarter. The commission lowered its full-year growth forecast to 1.3 percent from 1.7 percent and signaled the 2009 outlook may also be cut.

Still, the price of oil has fallen almost 30 percent from a July 11 record of $147.27 a barrel and the euro has dropped 12 percent against the dollar in the past three months, which may provide some relief to consumers and exporters.

The economy ``should recover by the end of the year,'' Wolfgang Franz, President of Germany's ZEW economic research institute, said in a speech in Frankfurt last night. Then, ``rate increases could be put back on the table for discussion.''

ECB council member Axel Weber said in an interview published Aug. 27 that ``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.''

The ECB said in its monthly bulletin today that, while current rates should help it achieve price stability in the medium term, inflation risks remain on the ``upside.''

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