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August 31st 2011:  Preview  -  Inflation fall would trigger ECB U-turn

 

The latest flash Euro-zone inflation estimate will be released on Wednesday and the data could be decisive in triggering an ECB policy u-turn.  Any decline in the flash inflation reading from 2.5% would increase the probability that the central bank will abandon talk of further interest rate hikes and any figure below 2.2% would guarantee such a policy shift with increased speculation over a cut in benchmark rates within the next few months.

The Euro would tend to fall on weaker than expected data. Although selling pressure may be limited as there would also be greater optimism that the debt crisis can be contained, any inflation decline would be another major barrier to sustained Euro gains.

In testimony to the European parliament on Monday, ECB president Trichet stated that there was an assessment of inflation risk being undertaken within the bank and these new staff projections would be made available to the council ahead of next week’s interest rate decision. Over the past few weeks there has been a sharp deterioration in business confidence across the Euro area and the German economy has not been immune to these pressures with substantial  declines in the IFO and ZEW business confidence indicators. The ECB must be forward looking in its analysis and its very difficult to see where inflationary pressures are going to come from in the short term.  There is little scope for previous cost increases to be passed on to consumers and energy prices have also fallen from recent peaks.

As far as money supply is concerned, benchmark M3 rose 2.0% in the year to July and overall credit growth remains subdued while the Euro is still robust against the dollar which will help keep import prices under control. The preliminary German data recorded a 0.1% decline in prices for August which will help keep inflation down for the Euro area as a whole.  The annual rate will continue to reflect previous increases in energy prices for the next few months, but will then drop sharply.

The ECB will also need to consider the Euro-zone debt risks and although its focus is on inflation, the bank must also be aware that a hawkish policy approach will increase stresses within the Euro area which would also increase pressure to intervene and buy more peripheral bonds. International pressures will also be significant as the ECB will not want to be isolated within G7 where interest rates are being kept at ultra-low levels.

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