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The ECB will remain roughly neutral with a "wait and see" approach on Thursday. The ECB remains caught in a balancing act between dwindling growth prospects with downside risks and high inflation with upside risks, and fears of second-round effects.

Overview

More of the same has been the theme in the last month. On the one hand, inflation remains well above target and commodity prices are surging even though the euro is a mitigating factor. Risks to inflation will remain to the upside and there is little to alleviate the ECB’s fears of second-round effects. On the other hand, the growth prospects continue to deteriorate even though forward-looking economic indicators have been mixed. For example, Ifo continues to defy logic and rose again, while the trend in the PMIs is clearly downward.

The international outlook continues to worsen not least due to a continued deterioration of the outlook for the US economy. The Q4 national accounts for Euroland showed a modest growth of 0.4%, generated almost entirely by investments and exports even though the growth rates are less stellar than previously. Private consumption was very weak and actually fell in Q4. The growth composition should make Euroland quite sensitive to global growth and the financial crisis, further underscoring the risks surrounding the economic outlook for Euroland.

Specifically, the ECB will keep the following statements, which also underline its current dilemma: "risks to price stability over the medium term are on the upside" and "risks surrounding the outlook for economic activity lie on the downside". We also expect the ECB to again stress the unusually high uncertainty from the reappraisal of risks on the financial markets. Overall, the statement will be close to the one from February.

Market interpretation

The interpretation of the statement and the press conference by the financial markets is a tricky matter at the moment. The markets are well ahead of the ECB, but the markets do not expect miracles from the ECB in the short term. A slightly more concerned view on growth balanced by even-higher inflation worry is the general expectation. We expect the tone to be close to market sentiment and we do not think the markets are expecting that much from the ECB following last month’s softening of tone.

ECB staff projections

The March meeting also brings with it the publication of the quarterly forecasts on growth and inflation, which are also bound to receive some attention. The ECB’s dilemma is going to be clear in the staff projections: The growth forecasts will again be lowered, while the inflation estimates will be lifted once more. We expect the growth forecasts for 2008 to be lowered to 1.6%, while the inflation estimate is expected to be lifted to 2.7%. The 2009 growth forecast is set to be lowered to 1.8% and inflation upped to 2.0%, preaching ECB’s target for inflation.

Note that the ECB projections are 1) Staff projections and not the council’s forecast, and 2) Based on forward interest rates and that the cut-off date is the middle of the previous month. Hence for the coming projections the cut-off date is around 15 January, where market levels for forward rates are very close to the current levels where the market is pricing 75-100bp of cuts by mid-2009.

The inflation projection could be seen as a signal that the ECB does not agree with the current market expectations in the sense that it would overshoot its target in 2009 if it cut rates as priced. It is not clear, though, whether 2009 inflation has to be below 2% in order for the ECB to meet its mandate. It could, in principle, argue that inflation will drop below 2% during 2009 - which is also the medium term - and hence would still be in line with its target. It will be an interesting press conference on Thursday.

Danske Bank
http://www.danskebank.com/danskeresearch

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