Euro Area

11.02.2008 Euro Area - ECB

ECB’s Governing Council left refinancing rate unchanged at 4.0% for the sixth consecutive time. During the press-conference Mr. Trichet, the President of ECB stated “On the basis of our regular economic and monetary analyses, we decided at today’s meeting to leave the key ECB interest rates unchanged. This decision reflects our assessment that risks to price stability over the medium term are on the upside, in a context of very vigorous money and credit growth. The current short-term upward pressure on inflation must not spill over to the medium term. The firm anchoring of inflation expectations over the medium and long term is of the highest priority to the Governing Council, reflecting its mandate. Against this background, the Governing Council remains committed to preventing second-round effects and the materialization of upside risks to price stability over the medium term. As the reappraisal of risk in financial markets continues, there remains unusually high uncertainty about its overall impact on the real economy. While the economic fundamentals of the Euro area are sound, incoming data have confirmed that the risks surrounding the outlook for economic activity lie on the downside. We will continue to monitor very closely all developments over the coming weeks”.

Commenting on the economic conjuncture Mr. Trichet stated “The latest information on economic activity around the turn of the year points to a more moderate pace of growth in the Euro area than the quarter-on-quarter rate of 0.8% observed in the third quarter of 2007. This assessment is in line with indicators for business and consumer confidence which, while having declined over the past few months, overall remain consistent with ongoing growth (chart 1). The slowdown in the economies of some of the Euro area’s major trading partners is likely to have an impact on Euro area real GDP growth in 2008, both domestic and foreign demand are expected to support ongoing growth. The fundamentals of the Euro area economy remain sound. The Euro area economy does not have major imbalances”. To confirm this position he enumerated the following factors: sustained growth of corporate profitability and income and reduction of unemployment rate to levels not seen for 25 years.

Consumption expenditure will remain an important source of economic growth, thanks to the high personal income. On the basis of this view, ECB’s experts forecast economic growth in a range between 1.5% and 2.5% in 2008, which is 0.3% lower than the prior level (table 1).

In the long term, there is a downside risk for the Euro area economic growth, which may be caused by increased volatilities of financial markets, further oil and commodity price rises, as well as global imbalances and protectionist pressures.

The preliminary CPI rate for January rose by 0.1% to 3.2% over year. Related to the inflation acceleration the President of ECB said “The annual CPI rate will most likely remain significantly above 2% in the coming months and moderate only gradually in the further course of 2008. This confirms our expectation of a protracted period of temporarily high rates of inflation”. It will be recalled that in December central bank experts revised upward forecasted rate of CPI by 0.5%. In particular, they are expecting inflation from 2% to 3% in the next year. These forecasts are based on two key assumptions. Firstly the ECB staff projections assume that recent oil and food price dynamics and their impact on CPI will not have broadly-based second-round effects on wage-setting behavior. A further key assumption is that growth pace of oil, metals and wheat prices will be moderating.

In the medium term the upside risk of inflation includes the possibility of further increases in the prices of oil and agricultural products. Taking into consideration the favorable momentum of GDP growth observed over the past few quarters and the positive signs from labor markets, stronger wage developments than currently expected ones may occur and an increase in the pricing power in market segments with low competition could materialize. An additional upside pressure on inflation could arise in the similar development of events.

Discussing the monetary policy President of ECB underlined that the monetary aggregate M3 rose by 11.5% in December, whereas M1 growth continues to moderate (chart 2). Monetary base dynamics during the last quarters came out mainly from the flattening of the yield curve, possibly due to the restructuring of certain banking groups. However, even taking into account these special factors, the underlying rate of money and credit expansion remains strong. Moreover, increased financial market volatility has not led to banks portfolios substantial shifts into monetary assets, as was the case between 2001 and 2003.

We think the sharp slump of mortgage backed securities prices and credit crunch in the interbank market completed the policy of interest rates gradual rising by ECB. Firstly the fact that medium term moderation of the US economic growth due to the crisis in real estate market will have negative impact on the Euro area GDP. Second quarter in a row construction has been reducing, likewise the real estate prices growth stopped in the southern countries of the Euro Area.

Furthermore the growth rate of loans to private sector decelerated to 7.6% over year compared with 12.1% April 2006 peak level (chart 3). Demand for mortgage loans is falling on the background of high medium and long term interest rates. In the end, the noticeable gain of money supply didn’t cause an acceleration of core inflation. “Freeze” bond market, backed by Subprime and Alt-A mortgages, relatively high interest rates and unwillingness of the banks to lend each other will have a negative impact on money supply growth and therefore on the inflation.

High level of headline inflation is maintained by such factors as oil and food. However, in the view of the most analysts of leading investment banks energy carriers and agricultural prices will fall or at least decelerate their growth pace in 2008. Since the central bank representatives pointed out high inflation as a major argument to maintain the interest rates at the current level, the possibility of latter’s deceleration will favor at least 50 basis points cut of the refinancing rate till the end of this year.

EURO AREA ECONOMIC INDICATORS

Chart 1

	2006	2007 *	2008 *
CPI	2.2	1.9 - 2.1	1.5 - 2.5
Real GDP	2.9	2.2 - 2.8	1.8 - 2.8
- Private consumption	1.9	1.4 - 1.8	1.5 - 2.7
- Government consumption	1.9	1.3 - 2.3	1.2 - 2.2
- Fixed capital formation	5.2	3.6 - 5.2	1.4 - 4.6
- Exports	8.2	4.6 - 7.4	3.9 - 7.1
- Imports	7.9	3.7 - 6.7	3.6 - 7.0

Source: ECB Staff Projections

Chart 1

Source: Bloomberg

Chart 2

Source: Eurostat; ECB

Chart 3

Source: Bloomberg

11 February