Inflation fears steer ECB away from rate cuts

Inflation fears steer ECB away from rate cuts

August 27 2008: Ralph Atkins writes in Frankfurt for The Financial Times:

European Central Bank policymakers signalled fresh alarm over the outlook for eurozone inflation on Wednesday even as German data indicated that headline inflation rates had fallen from record highs.

Comments by ECB governing council members suggested cuts in interest rates were far from being considered by the bank, despite the abrupt slowdown in eurozone growth.

Axel Weber, Germany’s Bundesbank president, warned that another increase in borrowing costs might be necessary when growth recovered.

Reflecting lower energy costs, Germany’s annual inflation rate dropped from 3.5 per cent in July to 3.3 per cent in August on a European harmonised basis, the country’s statistical office reported.

Economists forecast that eurozone figures, released on Friday, would show inflation across the 15-country region had also fallen, perhaps to 3.9 per cent or 3.8 per cent from the record 4 per cent in July.

But eurozone inflation still remains significantly higher than the ECB’s goal of an annual rate “below but close to” 2 per cent.

Lucas Papademos, ECB vice-president, warned in a speech in Buenos Aires that labour cost growth had accelerated and that inflation was likely to remain above the ECB’s target “for a considerable period of time before declining only gradually in the course of 2009”.

The ECB’s fear is that high inflation rates will become entrenched through “second-round effects” with slower growth having little dampening effect. The emergence of a wage-price spiral would “require a stronger degree of monetary tightening in order to achieve price stability”, Mr Papademos warned.

Earlier Jürgen Stark, an ECB executive board member, told a German newspaper that second-round effects had become “broad-based”. Heightening the ECB’s concerns, IG Metall, Germany’s powerful engineering trade union, has indicated it could demand a wage increase of up to 8 per cent in forthcoming wage negotiations.

The ECB policymakers’ comments reinforced expectations that ECB interest rates would remain on hold at least until well into next year.

Unlike the US Federal Reserve – which has slashed US borrowing costs in the past year – the ECB sees its job as focused on controlling inflation rather than riding to the rescue of economic growth.

Eurozone wages and prices are also slower to adjust then in other economies, strengthening the case for a more cautious stance by the ECB.

At the same time, the ECB is sticking to its forecast that eurozone growth could pick up this year. Gross domestic product contracted by 0.2 per cent in the second quarter and activity would remain “subdued” in coming months but “gradually recover in the fourth quarter of this year and in the course of 2009”, Mr Papademos said.

The ECB raised its main interest rate to 4.25 per cent in July largely to underscore its determination to counter second-round effects.

Mr Weber at Germany’s Bundesbank told Bloomberg that discussion about lower eurozone rates was “premature”. He went on: “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 Bundesbank president expected that ECB forecasts for eurozone growth, to be released after its interest-rate setting meeting next week, would be revised downwards slightly while its inflation forecasts might be “slightly higher”.

Copyright The Financial Times Limited 2008