Euro Area

14.04.2008 Euro Area - ECB

ECB’s Governing Council left refinancing rate unchanged at 4.0% for the eight 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. The latest information has confirmed the existence of strong short-term upward pressure on inflation. In fact, we are experiencing a rather protracted period of temporarily high annual rates of inflation, resulting mainly from increases in energy and food prices. The latest information also clearly confirms our assessment of prevailing upside risks to price stability over the medium term, in a context of continuing very vigorous money and credit growth. The economic fundamentals of the Euro area are sound. However, the level of uncertainty resulting from the turmoil in financial markets remains unusually high and tensions may last longer than initially expected. Against this background, the firm anchoring of medium to longer-term inflation expectations is of the highest priority to the Governing Council. We believe that the current monetary policy stance will contribute to achieving our objective. The Governing Council remains strongly committed to preventing second-round effects and the materialization of upside risks to price stability over the medium term. 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 also underpins previous expectations of moderate but ongoing growth in the first quarter of 2008. Overall, the Euro area economy has sound fundamentals and does not suffer from major imbalances”. To confirm this position he enumerated the following factors: robust economic growth in emerging countries, sustained growth of corporate profitability and income, high level of capacity utilization and reduction of unemployment rate to levels not seen for 25 years (chart 1). Consumption expenditure will remain an important source of economic expansion, thanks to the high personal income. ECB’s experts forecasted economic growth in a range between 1.3% and 2.1% in 2008 (table 1). In the long term, downside risk for the Euro area economic growth may be mainly caused by current developments on financial markets. Further oil and commodity price rises, protectionist pressures and global imbalances will also have a negative impact.

The preliminary CPI rate for March rose to 3.5% over year. Related to the inflation acceleration the President of ECB didn’t say anything new “We are currently experiencing a rather protracted period of temporarily high annual rates of inflation. The annual HICP inflation rate is likely to remain significantly above 2% in the coming months, moderating only gradually over the course of 2008”. It will be recalled that central bank experts forecasts inflation from 2.6% to 3.2% in the next year. These forecasts are based on two key assumptions. Firstly the ECB staff experts 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, increases in administered prices and indirect taxes. 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 11.3%February,due to the private sector lending expansion (chart 2). While M1 growth moderated further, as higher short-term interest rates have increased the cost of holding the liquid assets, the volume of time deposits sharply rose. Monetary base dynamics during the last quarters came out mainly from the relatively flat yield curve. Such a shape of yield curve has made holding monetary assets more attractive, compared with riskier, long term instruments. Nevertheless, the increased financial market volatility has not led to banks portfolios substantial shifts into monetary assets, as was the case during 2001 and 2003.

We think that ECB is establishing terms for a new monetary policy, in the context of which the base interest rate will be significantly lowered. This opinion is based on the below mentioned factors. Firstly the fact that medium term moderation of the US economic growth due to the crisis in real estate market will have a negative impact on the Euro area GDP. Third 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 6.7% 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 the 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

Table 1

	2007	2008 *	2009 *
CPI	2.1	2.6 - 3.2	1.5 - 2.7
Real GDP	2.6	1.3 - 2.1	1.3 - 2.3
- Private consumption	1.6	1.1 - 2.7	1.0 - 2.4
- Government consumption	1.9	1.1 - 2.1	1.0 - 2.0
- Fixed capital formation	4.6	0.5 - 3.1	0.2 - 3.4
- Exports	5.7	2.6 - 5.6	3.1 - 6.3
- Imports	4.9	2.0 - 5.4	2.9 - 6.3

Source: ECB Staff projections

Chart 1

Source: Bloomberg

Chart 2

Source: Bloomberg

Chart 3

Source: Bloomberg

14 April