ECB remains hawkish on rates despite lower eurozone inflation

BRUSSELS – Lower oil prices helped cut September eurozone inflation to its lowest in 3 1/2 years and price growth expectations eased too, data showed yesterday, but this is unlikely to stop further ECB rate rises. The European Union’s statistics office estimated prices grew 1.8 percent year-on-year in September – the lowest rate since March 2003 – down from 2.3 percent in August and below market expectations of 1.9 percent. But although it is now at the European Central Bank’s target of «below, but close to 2 percent,» economists said inflation would rebound in a few months as the oil price effect wears off, Germany raises Value Added Tax and the economy powers ahead. «Over the coming months, headline inflation will push back above 2 percent and remain there on average over 2007. The data should therefore have little impact on ECB policy,» said Mitul Kotecha, head of global foreign exchange research at Calyon in London. Markets expect the ECB to raise interest rates next Thursday by 25 basis points to 3.25 percent and price in a good chance for them to reach 3.75 percent by mid 2007. Hawks on the ECB board are likely to get a boost from the European Commission’s eurozone economic sentiment indicators which hit multi-year highs in September, against expectations of a small decline, pointing to a continued economic upswing. «As this fits nicely with the ECB’s optimistic projection for GDP growth in the second half of 2006, central bank rates are likely to rise further,» said HVB economist Marco Kramer. But hard data for the eurozone’s two biggest economies added a note of caution to the upbeat sentiment indicators. German retail sales, which show household demand, were unchanged in August against July despite expectations of a rise, pointing to weak private consumption in the eurozone’s biggest economy. The data followed a smaller than expected decline in unemployment in September. In France, unemployment rose in August instead of the expected decline. Yet ECB Governing Board member and Bundesbank chief Axel Weber said in Berlin growth in Germany could get a boost this year and next thanks to falling oil prices. The ECB is worried that with the economy growing strongly, unemployment falling and borrowing costs low, there is potential for an inflationary upswing in wages and prices. While the drop in inflation is likely to be welcomed by the ECB, the bank’s Executive Board member Jose Manuel Gonzalez Paramo said on Thursday that monetary policy could not respond to short-term changes in price trends, such as oil. A critical factor to the ECB’s goal of keeping inflation in check is anchoring inflation expectations at low levels, because expectations affect price behavior and could help keep inflation below 2 percent on a sustained basis. The monthly European Commission survey showed some success in that respect with consumer inflation expectations down to 24 points from 26 points in August and selling price expectations among manufacturing industry unchanged at 13. «One of the ECB’s major objectives is to keep inflation expectations in check to avoid second round effects, and today’s release goes into the right direction, albeit not being an ‘all clear’,» said Astrid Schilo, economist at HSBC. ECB policymakers have made it clear that a few months of relief will not deter them from raising rates. Economists are now asking whether the bank will keep on raising rates in 2007, when a global growth slowdown, the German VAT hike, higher interest rates and a stronger euro are likely to slow eurozone growth. Sentiment data from the European Commission showed both businesses and consumer confidence was still on the rise in September after an earlier dip. Economic sentiment in the eurozone rose to 109.3 points – its highest level since February 2001 – from an upwardly revised 108.3 points in August, thanks to higher confidence in industry, construction, the retail sector and among consumers. The Commission’s eurozone business climate indicator jumped to to 1.46 points in September, its highest level since June 2000, pointing to a third-quarter pick-up in industrial output. «For the ECB it means they need to go to sort of neutral, because with good growth you don’t need low rates. But whether they need to go beyond 3.5 percent in the absence of inflationary pressure is a very open question and I think they will stop at 3.5 percent,» said Holger Schmieding, economist at Bank of America. Financial integration In his Berlin speech, ECB’s Weber said that more modern and integrated financial systems are essential for faster European growth but policymakers should let markets make the running. Authorities could best help by laying the right ground rules, including encouraging venture capital investment and the use of more innovative financial products such as asset-based securities, he said. «Financial integration and modernization are, first and foremost, market-driven processes,» Weber told a conference organized by the Bundesbank and the Center for Financial Studies. «Policymakers should support them by providing an effective legislative and regulatory framework, but should not intervene,» he said. Weber made the remarks the same day that the ECB released its latest report on financial integration in the euro area, which measures progress in building a single financial market. Similarly to last year, it found the retail banking sector was the most fragmented in the region. It said more progress was needed in commercial banking and capital-market related activities. Equity markets, however, increasingly trade on common factors and debt instrument markets show a high degree of integration. But the infrastructure underlying these markets are wanting, the ECB said. To foster integration, the ECB is proposing to set a common stock and bond securities settlement platform, though the major private sector house Euroclear has questioned the plan. In his speech Weber said wider use of securitization, which allows a company to turn future cash flow into a tradeable, bond-like security, would improve risk allocation and free up bank capital in the region. He also repeated calls for EU members to speed up structural reforms to boost employment and strengthen economic growth. He noted economic volatility had eased in the past 20-30 years, improving the way markets worked, and said reasons included better central bank policy as well as «plain good luck.»