Business-Insider

The ECB is expected to hold rates on Thursday and while ECB President Jean-Claude Trichet is expected to sound hawkish at the press conference, economists (and traders) believe the ECB will find itself unable to raise rates in coming months. The knock-on effects from the global credit crisis and sub prime debacle will liklely slow Euro-area growth to around 2.0 percent in 2008 from 2007's 2.6 percent rate.

There are reasons enough for Trichet's hawkish tone; Inflation held at 3.1% in November and December, far above the ECB's 2.0% target and he said on Jan. 5 that the economy faces a "more protracted'' period of elevated inflation than previously expected, due to the "substantial increase'' in oil, food and commodity prices which is "having a strong upward impact on inflation.'' The "danger of second round effects" in some economies and the risk of inflation "spiraling" was considered "an important risk calling for no complacency."

Prices paid to European manufacturers accelerated in November by 4.1 percent from a year earlier, the fastest pace in almost a year, because energy costs jumped 7.8 percent in November after rising 4.2 percent the previous month. Excluding such costs, producer prices rose at a still-uncomfortable 3.2 percent from a year earlier.

Also, unlike the Federal Reserve the ECB takes the money supply into consideration when making policy. Eurozone November M3 was up a strong 12.3% on a year-over-year basis (unchanged from Oct).

As far as the global credit crisis is concerned, on January 6th at the BIS meeting Trichet said central bankers were "very satisfied'' with their efforts to calm money markets. The ECB injected an unprecedented $500B in the economy last month and Trichet indicated that further Central Bank actions were possible even though that he had "very good reason'' to consider that financial institutions will act to "appease those tensions'' on money markets. "What we did was very important and I would say helped considerably to stabilize the situation,'' Trichet said. "But we never said we could change the overall situation. It's a process which is ongoing.'' And even though Trichet believes the impact of the market "correction'' on the real economy "is still to be fully understood," he still see's "growth continuing at a pace which is quite robust, even if there is a little bit of a slowing down."

However, despite all the hawkish rhetoric there are serious downside risks to growth in external demand stemming from the expected slowdowns in U.S. and U.K. economies. On December 7, the OECD said the Euro area’s Composite of Leading Indicators decreased by 0.1 point in October and stands 1.9 points lower than a year ago. And despite a strong job market, consumer confidence is waning. Eurozone retailers experienced a poor month of December, according to the Bloomberg Eurozone Retail Purchasing Managers' Index. The index was little-changed in December from the previous month's 45.9, at 46.0 and was the third-lowest figure in the surveys four-year history, signaling a decline in euro area retail sales for the third successive month. Germany's retail sales, adjusted for inflation and seasonal swings, fell 1.3 percent in November, after sliding a revised 2.3 percent in the previous month while production fell 0.9 percent in November from October.

So even though the ECB has sounded quite hawkish lately, due to the "ongoing process" of easing credit market tensions, potential U.S. recession and expected moderation in growth the ECB is very likely to take a "wait and see" approach, which means you should not expect to see an increase in the main target rate anytime soon. Bloomberg noted that, "Interest-rate futures yesterday showed traders pared bets the ECB will raise interest rates this year after reports showed German industrial production, exports and retail sales unexpectedly declined. The implied yield on the Euribor June futures contract fell 4 basis points yesterday to 4.34 percent."

Still, even with the downside risks for growth don't expect to see the ECB reduce rates anytime soon. Aside from the fact that inflation and money supply readings are high, many in the bank view the U.S. sub prime crisis to partially be the result of loose monetary policy which kept interest rates too low for too long and believe it's dangerous to use monetary policy as a stimulant for the business cycle and economy. And although growth is expected to slow, the ECB fully expects the Euro-area economy to withstand even a modest recession in the U.S. and U.K. economies. Along with good levels of job creation, business investment (because of generally strong corporate balance sheets) and exports to emerging market economies are growing.

EUR/USD has basically traded in a 400 pip range since the begining of December and could stay within that range until things become more clear. The bottom line is that the ECB is far closer to raising rates then the Fed and is likely to move as soon as conditions allow.

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