Facing Pressure to Cut, ECB Will Likely Hold
The European Central Bank is likely to keep its title as the last inflation hawk standing at its rate-setting meeting Thursday, but as fears of a global economic slowdown grow, calls for easing will only increase.
With high inflation, falling euro-zone service sector growth and slow retail sales during the key Christmas period, the ECB is expected to keep its short-term rate at 4 percent.
The Euro Zone Services Purchasing Managers Index fell a sharp 1.4 points to 50.6 in January, to a four-and-a-half year low.
And once again, the market will have to hunt for clues in ECB President Jean-Claude Trichet's press conference to see if the monetary committee will stick to its 'wait-and-see' approach.
The Federal Reserve has taken interest rates from 5.25 percent in August down to 3 percent, while the Bank of England recently trimmed rates by a quarter point. But the ECB has kept rates unchanged since June 2007.
"They still want to tough it out, to look through the downturn, in Q1 and Q2 in the US, and they are hoping that the US economy will gain traction later on this year," Christoph Hausen, economist at Eurohypo told CNBC. "But one of the effects of a recession is that often it lasts longer than anticipated."
Markets currently price in the ECB easing rates in the second half of the year -- according to the three-month Euribor -- as inflation continues to pose the greatest threat to the euro zone economy.
"For the moment, they want to keep their inflation-fighting credentials, and therefore are still using very tough language and tomorrow (Thursday) I expect they will use very tough language," Hausen said.
"So there is no gradual softening of the tone. But later this year, maybe in early summer, they will react to the economic forecasts and swiftly turn to a rate-cutting mode."
Euro zone inflation hit a record 14-year high of 3.2 percent in January, driven by oil and food prices. That's well above the ECB's comfort rate of below 2 percent.
Underlying core customer price inflation (CPI), measured by excluding volatile unprocessed food and energy costs, and the producer price index (PPI), which is more influenced by raw materials and less by labor costs, have risen steadily throughout 2007 and into 2008, according to Reuters.
Euro zone producer prices rose 0.1 percent in December from November, and were up 4.3 percent year-on-year, EU statistics office Eurostat said Feb. 4.
The European Central Bank remains concerned about future inflation pressures, including the risk of stronger-than-expected wage demands and a pass-through of past oil price rises into consumer prices, and do not feel that there is enough evidence yet of an economic slowdown in Europe.
"Nothing says we are going to have a major slowdown," Christian Noyer, French ECB policymaker, told French radio station BFM Jan. 28. "We have not seen in the production and consumption figures many signs of a major slowdown."
But economists are worried that if the central bank does not act soon it will be too late, as business confidence and consumer morale continue to get hit hard in the 27-country bloc.
"I think the kind of hawkish rhetoric we have seen in recent weeks with an actual threat of rate hikes was really exceedingly aggressive," Marco Annunziata, chief economist from UniCredit Markets & Investments, told CNBC.
"At most, we will see the ECB acknowledging some increase in growth risks, but they have a very difficult situation," Annunziata said. "They have to change their rhetoric gradually to avoid losing credibility, but they have to start now."
Rate cuts should come between June and September, he added.
"The concern is that the ECB continue to give the impression of Europe as a happy island which can escape the global slowdown and we've seen how markets can punish a central bank that is severely behind the curve."
-- Reuters contributed to this report