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ECB to hold rates as growth slides, inflation high

FRANKFURT - The European Central Bank is expected to leave interest rates at a seven-year high of 4.25 percent on Thursday as evidence grows of a sharp drop in euro zone economic growth and inflation hits a fresh record high.

After raising rates for the first time in a year last month, economists expect the ECB to take a breather and all 85 analysts polled by Reuters expect no change on Aug. 7.

Most predict unchanged benchmark credit costs well into 2009 and a run of weak data has backed expectations that the ECB's next move will be a cut, even though inflation in the 15-nation region hit 4.1 percent in July, the highest on record.

Many economic indicators are at their lowest levels since 2003, when the euro zone's annual growth rate more than halved to 0.4 percent, Germany was in recession and interest rates were cut to a record low of 2.0 percent.

But economists expect ECB President Jean-Claude Trichet to show caution at his news conference following the rate decision, probably repeating the message from July that the ECB has no bias but will do whatever is needed to control inflation.

Over the last month, oil and food prices have eased back and market inflation expectations have stabilised -- a welcome sign for the ECB, which aims for inflation of just under 2 percent.

Governing Council members meet in Frankfurt at 0700 GMT on Thursday, having formally abandoned the practice in the ECB's early years of holding the August meeting via teleconference.

‘I expect no major change in the rhetoric, maybe a slightly softer stance acknowledging more the risks to growth and expressing hope that the correction in commodity prices proves permanent,’ UniCredit economist Marco Annunziata said. ‘Commodity prices have cooled off but there is a lot of volatility and the ECB cannot lower its guard yet.’

Benchmark US oil prices were around $125 per barrel on Monday, having fallen as much as $27 late last month from their high above $147 per barrel on July 11.

Soaring energy costs pushed euro zone producer prices to a record 8.0 percent annual increase in June, data showed on Monday, and both manufacturers and service providers report rising cost pressures.

Euro zone central bank sources told Reuters that the ECB would raise rates again if the inflation outlook deteriorated, although others expected inflation to ease in the next few months on the back of cheaper oil.

Slower economic growth should also lessen the potential for workers to demand big wage demands and for firms to raise prices strongly because of the high inflation rate.

HIKE WINDOW CLOSED

Most economists believe the window of opportunity for rate rises has closed, following gloomy data. This has dragged down the euro and sparked fears of economic contraction in the second quarter, and possibly the third as well.

The Reuters poll showed the chance of another rate rise by year-end was just 20 percent, roughly in line with financial market expectations. In contrast, two in three analysts expected at least one rate cut by the end of 2009.

When Trichet flagged a July rate rise in June -- to the shock of most observers -- he made clear that some policymakers were reluctant to tighten policy. Economists said winning support for any further tightening would be even tougher due to the economic outlook and financial market tensions.

Benchmark three-month Euribor interest rates hit a 7-1/2 year high on Monday, despite extra measures agreed with the US Federal Reserve and the Swiss National Bank to add extra liquidity to markets.

Euro zone economic sentiment fell to its lowest level in more than 5 years in July, and consumer and business confidence in major economies is also at record or historic lows. Sentix investor morale fell in August to its lowest since July 2003.

Adding to the gloom, factory and services activity also contracted at the fastest pace seen since 2003, with the manufacturing Purchasing Managers' Index falling to 47.4.

‘Amid a plunge in leading indicators, which is forcing even the more sanguine observers to concede that a technical recession -- two consecutive quarters of declining GDP -- can no longer be ruled out, we maintain our view that the doves will likely prevail,’ Bank of America economist Holger Schmieding wrote in a note to clients.

‘We expect the ECB to be on hold for at least the next 12 months. The inflation risks look set to fade even without the ECB exacerbating the downside risks to growth by a further rate increase.’