Danske Bank

Euroland: ECB Cuts Postponed

As inflation continues to surprise on the upside, the prospect of ECB cuts in the short term are fading. The ECB's mandate is quite clear. It can only support growth if it believes that price stability is to be achieved in the medium term. And with inflation now standing at 3.5% - clearly above the objective of below 2% - the ECB is boxed in despite the rising headwinds on Euroland growth. As stated in our new yield forecasts yesterday, we have moved our expectation of an ECB rate cut of 25bp from June to September this year. We still expect three rate cuts over the next 12 months, as we see further easing of 25bp in December and March.

What will pave the way for rate cuts? First of all, we expect inflation to peak out in current months (see chart). Inflation has stayed higher for longer than we expected, but we still believe we are close to the peak. Secondly, growth risks have risen further and our outlook for GDP of 1.4% this year is below the ECB's own forecast of 1.7%. Headwinds to growth are piling up, with the material strengthening of the euro, weaker growth on export markets, high oil and food prices, a cooling housing market and a tightening of credit standards. In fact, growth has already slowed down to around trend growth of 2% and we believe we will see a further slowing to 1% in the second half of the year. Interestingly, the IMF today published new growth forecasts in which it revised Euroland growth down to 1.3% in 2008 and 1.1% in 2009. IMF also wrote that, "[the] ECB can now afford some easing of the monetary stance". This is the first time one of the international organisations has flagged the prospect of rate cuts.

The ECB's comments lately have continued to stress that the ECB's main objective is price stability and that the current rate will work to achieve this. The ECB's council member, Mr Noyer, said on Tuesday that a pre-condition for rate cuts is that inflation expectations are firmly anchored. In this respect, the release of consumer inflation expectations on Monday was very important as it actually showed a decline in inflation expectations. Hence it seems the current high inflation is not leading households to also expect higher inflation in the future but instead they realise that the jump in oil and food prices is temporary, rather than a continuing development.