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The ECB's Year of the Rat

Five months after the credit crunch started to hit Europe, the buzz word for the European Central Bank is still "uncertainty." Between the danger of rising inflation and the threat of economic slowdown, the bank appears to be handcuffed when it meets on Thursday.

And unable to take any definitive action, the central bank may be tempted to rely on superstition.

One prominent member of the ECB Governing Council, Christian Noyer, said recently that prophecies for 2008, the Year of the Rat in the Asian calendar, show that this is a favorable one for investment and savings.

"The prediction went on to say, every word is true, 'the influence of the rat curbs inflation.' As a euro-area central banker, I welcome this omen," Noyer told a meeting attended by Japanese central bankers this week, according to Reuters.

Not a bad joke,but the latest months have shown that the ECB has as muchchance of predicting the course of the economy by reading the stars as by using complicated economic models.

And its members, now swollen to 15 as Cyprus and Malta joined the single currency area at the beginning of the year, have started to fret as their economies are moving in different directions.

Hawkish Talk

The newest members of the euro zone have joined the hawkish camp, and are rattling their sabers for higher rates.

"That the ECB Governing Council has waited until the end of the year does not mean that it shouldn't be ready to raise rates further if that is necessary," Cypriot central bank governor Athanasios Orphanides recently told a German newspaper.

And the Slovenian member of the ECB council, Marko Kranjec, told Reuters that the bank was serious about raising interest rates if needed to head off inflation pressures.

After the last meeting of 2007, ECB President Jean-Claude Trichet conceded that the council's members were not unanimous in wanting to keep rates flat at 4 percent.

But this is not enough to bring change, analysts said.

"I think there are some members in the ECB council who would still like to raise the rate. But I don't think one member can change the majority's opinion," Veronika Lammer, head of fixed income research at Erste Bank in Vienna, told CNBC.com.

However, Trichet's message in the news conference following the decision later on Thursday is likely to stress the risk that energy and food price rises may fuel other price hikes.

"We would expect Mr. Trichet to keep up a very hawkish tone at the news conference following today's rate decision," Martin van Vliet, from ING Bank, wrote in a market note.

"He will probably repeat his call on all parties concerned to avoid second-round effects and may step-up his warnings that signs of second-round effects could provoke monetary tightening," van Vliet added.

Economies Still Strong

The economic data out of the euro zone has been mixed but it, too, seems to give some leeway to hawks in the council.

Stronger growth in France and Belgium led the euro zone's third-quarter economic rebound even higher than previously reported, data showed on Wednesday. Gross domestic product rose 0.8 percent in the July-to-September period against the previous three months, higher than the previously reported 0.7 percent.

However, retail sales in the euro-zone were weak, having dropped 0.5 percent monthly and 1.4 percent on an annual basis in November, signaling consumer wariness and economic weakness down the road.

Business sentiment also fell in December to the lowest level in almost two years, but the drop was much less than the markets had expected, with services confidence posting a partial recovery.

Inflation remained above 3 percent, compared with the below-2-percent comfort zone for the ECB, while pressures have been accumulating. Euro zone industrial producer price inflation rose to 4.1 percent in November from October's 3.3 percent rise, while unemployment remained at an historical 7.2 percent low.

And money supply in the euro zone also pointed to inflation dangers further along, remaining at a record high of 12.3 percent in November.

Inflation Fears Grow

Trichet reiterated his fears as early as Monday when, after a meeting of 10 main central banks in Basel, said that "there cannot be complacency when it comes to inflation and market correction," AFP reported.

All these point to the fact that the ECB might, this time, raise rates to fulfill its mission to protect price stability.

But virtually all analysts say the bank will stand pat.

"The signs of euro-zone economic slowdown are not that strong as to make them nervous. But with inflation at 3 percent, it's very difficult for them," Stefan Schneider, chief international economist at Deutsche Bank Research, told CNBC.com.

"They will continue to sit on their hands and talk hawkish," Schneider added.

If the newcomers to the club would be comfortable with higher rates, the old euro-zone members, notably France and Italy, could do with a cut.

French Finance Minister Christina Lagarde has again urged the ECB to consider boosting growth more important than fighting inflation, telling the International Herald Tribune this week that she had a "preference for temporarily higher inflation and higher growth."

"I hope this view is shared by some of our European partners and communicated to the European Central Bank," she said.

Workers' Unrest

Meanwhile, in France and in Germany demands for wage hikes grow louder and louder, while in Italy workers have asked for tax cuts to make up for rising inflation and stagnating salaries, giving the ECB more headaches.

And despite Trichet being pleased with last year's concerted efforts by major central banks to pump liquidity in the money markets to bring down short-time rates, these markets are still not totally back to normal.

"We are still too high (in the money markets)," Lammer said. "I don't think it's a matter of liquidity anymore, it's a matter of trust."

Banks and funds are still hoarding cash, as the bad news from the banking sector unfolds. Analysts are saying that until the banks' balance sheets data comes out at the end of the quarter, things are unlikely to settle down.

So the most probable scenario is that the ECB will once again be doing nothing, although some of the members of the Governing Council are aching to hike the rate.

But for the moment, they can only hope that the strong euro will fight inflation, since it dampens the effects of rises in the prices of oil and other commodities.

Failing that, they can always pray that the Year of the Rat prophecy comestrue.

Contact Europe: Economy

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