Tuesday, January 22, 2008

ECB Anti-Inflation Resolve May Be Sapped by Fed's Surprise Cut

By John Fraher and Simon Kennedy

Jan. 23 (Bloomberg) -- The European Central Bank's resolve to fight inflation may diminish following the U.S. Federal Reserve's emergency interest-rate reduction yesterday.

Investors increased bets on the ECB's first cut since 2003 after the Fed lowered its rate by three-quarters of a percentage point to 3.5 percent. European policy makers may now even consider a half-point reduction to spur confidence, said the Royal Bank of Scotland Group Plc's Jacques Cailloux.

``The question for the market is now the timing and size of ECB cuts rather than whether the ECB will cut at all,'' said Cailloux, the bank's London-based chief euro-area economist. He's reconsidering his forecast for a 3.5 percent rate by year-end, down from the current 4 percent. ``There are obviously risks now they could cut more than that.''

ECB President Jean-Claude Trichet may give the bank's first response to the Fed move when he speaks to European lawmakers today in Brussels. The ECB, whose sole mission is keeping prices in check, began toning down its anti-inflation rhetoric this month as fallout from the U.S. slowdown began to infect the euro- region growth outlook. While Trichet on Jan. 10 threatened to raise rates, Germany's Axel Weber said Jan. 16 that officials shouldn't ``over-dramatize'' a pickup in inflation.

Trichet is scheduled to appear at a meeting of the European Parliament's economic and monetary affairs committee beginning at about at 9 a.m.

The Fed cut, its first emergency move since the Sept. 11 attacks, came after global stock markets tumbled amid signs the world's largest economy is sliding into recession. The move spurred a rally in European stocks, though failed to stem a decline in U.S. indexes.

`Balancing Act'

While it may also increase pressure on the Bank of England to accelerate its interest-rate reductions, Governor Mervyn King late yesterday said U.K. inflation may match the fastest in at least a decade.

``We face a difficult balancing act in the course of 2008,'' King told executives in Bristol, in the southwest of England. ``But we start the year in a position in which the Bank Rate, at 5.5 percent, is probably bearing down on demand.''

All 30 economists in a Bloomberg survey forecast the Bank of England will reduce the benchmark interest rate next month by a quarter point to 5.25 percent after cutting it for the first time in two years in December. A Jan. 4 survey showed most economists forecast the rate will fall to 4.75 percent by the end of 2008.

`More' Cuts

``From a European and a U.K. perspective, the Fed cut adds to the risk of more and quicker rate cuts,'' said Amit Kara, an economist at UBS AG in London. Kara, a former economist at the U.K. central bank, predicts four cuts from the Bank of England this year and two by the ECB.

The widening interest-rate gap between the U.S. and Europe may spur gains in the euro, worsening the outlook for an economy already showing signs of a slowdown by hobbling exports. German investor confidence dropped to the lowest since 1992 in January and European manufacturing growth slowed in December.

``This market has been calling for help,'' said Alberto Espelosin, who helps to manage about $12 billion at Zaragoza, Spain-based Ibercaja Gestion. ``The ECB should follow suit.''

The yield on the ECB's June interest-rate futures contract fell to 3.88 percent yesterday from 3.94 percent. The euro, which touched a record $1.4967 on Nov. 23, rose 1.1 percent to $1.4613 after the Fed's announcement.

`Forced to Act'

``If it becomes clear that this is merely a temporary fix, and the situation deteriorates further, then the ECB will be forced to act,'' said Ken Wattret, an economist at BNP Paribas SA in London.

European inflation at a six-year high of 3.1 percent, breaching the ECB target of just below 2 percent, is limiting policy makers' room for maneuver.

``Our main worry is the latest high rate of inflation of 3.1 percent,'' ECB Executive Board member Juergen Stark said after the Fed cut, according to Die Zeit, citing an interview. The ECB is ``very concerned and alarmed'' by price developments in the euro region, it cited Stark as saying.

ECB Vice-President Lucas Papademos and council member Axel Weber both expressed confidence yesterday that Europe's economy will continue to grow around its potential rate of 2 percent.

Still, evidence has mounted that the European economy may be starting to feel the pinch of the U.S. slump. Industrial production shrank in November and banks told the ECB this month that they will tighten credit in the next three months.

``Conditions have changed dramatically of late and even from an ECB perspective, this is not the time to worry about inflation,'' said Audrey Childe-Freeman, an economist at CIBC World Markets in London.

Some members of the ECB's governing council have already softened their tone. Luxembourg's Yves Mersch said in a Jan. 15 interview that the bank should exercise caution amid ``downside risks to economic activity.''

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