ECB expected to confirm hikes are done

By David Mchugh

Associated Press

Published: Tuesday, Sept. 6 2011 9:00 a.m. MDT

FRANKFURT, Germany — The European Central Bank is expected to make it clear Thursday that its key interest rate will stay firmly on hold at 1.5 percent as inflation fears ease and eurozone governments struggle with the currency union's debt crisis.

Some economists and market participants, however, are speculating that simply keeping rates steady won't be enough to get Europe out of its predicament, no matter what the bank says now. They think that any sudden worsening of the debt crisis or a reversal for the eurozone's fragile economic recovery could force a dramatic rate cut in weeks and months ahead.

"Recent indicators suggest that this recovery has faltered," said Dermot O'Leary, an analyst with Goodbody Stockbrokers in Dublin who expects a rate cut as early as the first part of next year.

On Thursday, when no change is expected after the bank's 23-member governing council meets at the headquarters in Frankfurt, the focus will be on President Jean-Claude Trichet's news conference.

In particular, traders will seek confirmation of hints he dropped last week that the ECB is softening its assessment of inflation risks.

Trichet told a European Parliament committee that the bank's view of inflation was "under study." That was a noticeable shift away from the earlier view that inflation risks were "on the upside," tilted toward unexpectedly high price rises.

Economists took it as a strong hint that the ECB's key rate is now on long-term hold after two increases in April and May, which were aimed at normalizing credit costs after their record lows during the 2007-2009 financial crisis.

The recent turmoil caused by the eurozone's government debt crisis and fears that it could weigh on growth have cemented those views.

Indicators of business and consumer optimism have been sagging, an indication that the market volatility is shaking the wider economy, not just the financial sector. Second-quarter eurozone growth disappointed at 0.2 percent, as the currency's largest economy, Germany, grew by a bare 0.1 percent.

At the same time, the leaders of the 17 countries that use the euro are struggling to contain a crisis caused by bond market fears that some countries have taken on too much debt and will default, inflicting crippling losses on a shaky European banking system. The ECB is a key player in that struggle through its emergency program to buy Italian and Spanish bonds on financial markets, a risky move that has so far kept high bond market borrowing rates from sinking those countries' finances.

The bank's projections see inflation of 2.6 percent this year — above its goal of just under 2 percent — but falling to 1.7 percent next year. The bank's growth and inflation projects are due for revision on Thursday and those changes will provide more clues to the bank's thinking. Inflation remained at 2.5 percent in August.

Analyst Carsten Brzeski at ING in Brussels thinks Trichet will make the shift in inflation expectations clear. "With a weakening eurozone economy, slowing credit growth and waning inflationary pressure, it is hard to find a lot of upward risks to inflation."

Some experts even think that the crisis could force the ECB to make a dramatic course reversal in coming weeks or months and lower interest rates right back to 1 percent, as some economists have been urging it to do. Money market forward interest rates are even partly pricing in the chance of a rate cut later this year.

But Michael Schubert at Commerzbank said the only things that could push the ECB to cut rates would be a complete collapse in European growth or a shock to the financial system like the one after the bankruptcy of U.S. investment bank Lehman Brothers in 2008.

Unless that happens, Schubert says, the bank will stay with its position that keeping rates too low for too long can encourage markets to engage in excessive risk-taking with cheap credit.

"While we are the first to admit that the ECB would doubtlessly slash rates should the sovereign debt crisis escalate and spark a similar crisis to that following the Lehman bankruptcy in autumn 2008, we believe that concerns over the risks of a highly expansionary policy will predominate, so long as systemic problems can be avoided," Schubert wrote.

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