As expected, the ECB maintained its monetary status quo (for the eleventh straight month) at the meeting of its Governing Council held on Thursday 8 May, leaving its refi rate at 4%. The tone of statements made during the traditional press conference (in the introductory speech and during the Q&A session with journalists) has not changed. Inflation is too high, although it fell from 3.6% in March to 3.3% in April, and risks remain on the upside. In particular, the ECB remains determined to preventing the current rise in prices from leading to inflation expectations skidding out of control, as this might undermine price stability in the medium term. With regard to activity, while the ECB does not ignore the faltering in confidence indicators, it continues to believe in the capacity of the euro zone’s economy to weather its current problems, as its “economic fundamentals” remain “healthy”, even though it admits that the “level of uncertainty resulting from the turmoil remains unusually high”.  It is now certain that inflation will remain at a high level in the next few months, and in all likelihood will not drop under 3% before the very end of the year, helped by the combination of positive base effects on volatile components (food and energy),… as well as the impact of the slowdown in the economy we expect to be tangible in the second half. Indeed, while the euro zone’s GDP in Q1 (data published on Thursday 15 May) probably rebounded (primarily thanks to Germany), and should have grown 0.5% q/q, up from 0.4% in Q4 2007, this certainly does not foreshadow the full-year figure. In fact, even in the first quarter, year-on-year growth will likely decline to a marked extent, dropping to 1.9%, i.e. its fourth consecutive decline and its slowest pace in ten quarters. Leading indicators point to a further deceleration in activity, dragged down by the impact of the euro’s appreciation and the rise in commodity prices, the effects resulting from the spreading of the US recession and the tightening in monetary conditions. In this respect, the latest ECB’s quarterly survey reported a further tightening in lending terms and conditions by commercial banks.  Accordingly, GDP growth will likely fall  under its potential pace during the next few quarters and, for the year as a whole, growth will probably come in around 1.5%, i.e. decelerate markedly after rising 2.7% in 2007, and will likely be even lower in 2009. It is expected that at the Governing Council meeting held in June the ECB will be led to revise downwards its current GDP growth forecasts for 2008 and 2009, i.e. 1.7% and 1.8%, respectively. However, it could also revise its inflation expectations upwards (currently 2.9% in 2008 and 2.1% in 2009). Under these conditions, the monetary status quo should be maintained in the next few months, while a cut in the refi rate might occur in late 2008 — or even earlier should activity deteriorate faster and/or prices slow down earlier. For its part, the Bank of England’s Monetary Policy Committee (MPC) decided to leave its key intervention rate unchanged at 5%, at its meeting held on last Thursday. No press release was published, as is usual when the BoE leaves its rates changed, but it seems virtually certain that the main reason why the status quo was maintained consisted in concerns about inflation, highlighted by the previous meeting’s Minutes. Inflation, after coming in at 2.5% in March, will likely rise to 3% during the summer. The BoE therefore did not want to give the impression that it was downgrading its price stability objective to a secondary status. Nonetheless, by doing so, it has run the risk of remaining behind the curve, even as growth weakened in Q1, with GDP increasing by just 0.4% q/q, and risks that the slowdown might worsen are piling up. Moreover, underlying inflation is a mere 1.2%, whereas it was up to 1.5% just a few months ago. Apparently, therefore, no second-round effect resulting from the rise in food and energy prices has set in. By consequence, the BoE will likely resume its monetary easing cycle as early as its June meeting, with a 25-bp cut in the base rate, before accelerating its pace during the second half, when inflation ebbs. The Bank’s base rate could thus end the year at 4%. To view the charts and graphs please open the PDF file on the left.

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