European Bank expected to hold rates in short term

FRANKFURT - The European Central Bank is expected to hold credit steady at 3 per cent when it meets tonight (NZ time), but will lay the groundwork for its fifth interest rate increase since late last year, probably in October.

Softening inflationary pressures now that oil prices are starting to retreat, some weaker sentiment surveys and a slowdown in the US economy give the ECB some breathing room before delivering its next rate hike, analysts said.

But they have little doubt at least one more credit tightening lies in store for the 12-nation euro zone.

The bloc's economy grew at its fastest pace in six years in the second quarter at a 2.4 per cent annual rate. Official money remains very cheap, scarcely half a per cent after subtracting inflation. That has spurred robust lending. Borrowing by households and businesses is at double-digit levels. Unemployment has dropped to a five-year low at 7.8 per cent.

Meanwhile, inflation at 2.4 per cent in July has remained stubbornly above the ECB's 2 per cent ceiling -- all making further ECB rate hikes look inevitable.

"The looseness of monetary policy in the euro zone is of urgent concern to the ECB," said Klaus Baader, European economist at Merrill Lynch in London.

Axel Weber, ECB Governing Council member from Germany, made that clear in an interview with Reuters last week. "By all measures, monetary policy is very accommodative," he said.

"As the economy strengthens we will continue to withdraw the monetary stimulation because the economy is increasingly standing on its own feet," he added.

Already the ECB has raised rates a full percentage point since December. In early August, when it raised rates to 3 per cent, it quickened the pace from one hike every three months to a two-month gap. This raised the spectre that October and December were the next dates.

Accordingly, analysts expect ECB President Jean-Claude Trichet at his 1230 GMT news conference, which comes 45 minutes after the rate announcement, to choose phrases that confirm market expectations for a 0.25 percentage point increase on October 3.

The words "strong vigilance" over inflationary risks would be a red flag to markets for a pending ECB rate increase. That phrase was used ahead of three of the last four rate hikes while "exercise vigilance" was used ahead of the other move.

In money markets, the euro overnight index (EONIA) has priced in a 95 per cent chance for an October hike.

In a Reuters poll last week, all 61 economists also expected an October increase and a majority saw another hike to 3.5 per cent this year, and then a pause.

Further light on ECB thinking will be shed by new economic projections, due out after the rate decision on Thursday. If inflation prospects for 2007, now at 2.2 per cent mid point within a range, are lifted that would signal more tightening.

Equally important though will be the revised GDP growth trajectory, which is likely to be boosted given the euro zone's better than expected outturn in the first half of 2006.

"If GDP shows there is less slack in the economy, it probably hardens the case that the end level of interest rates may be higher than we thought before," said Rainer Guntermann, economist at Dresdner Kleinwort in Frankfurt.

Currently, ECB staff project GDP growth at 2.1 per cent this year, easing to 1.8 per cent next year.

However immense uncertainty surrounds the outlook and some investors think 2007 may disappoint, requiring a pause or cut in rates.

They cite budget tightening in Europe, a resurgent euro up 8.8 per cent against the US dollar in the past nine months and hitting records against the yen this week, a delayed hit to growth from crude oil costs and a building US slowdown.

"Additionally, there are no fundamental inflationary risks that merit a restrictive (monetary) course," said Elga Bartsch, economist at Morgan Stanley, which expects the ECB to cut rates again in 2007 after reaching a 3.5 per cent peak.

- REUTERS