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Cut Rates? The ECB Won't Hear of It

In all likelihood,the European Central Bank will, again, do nothing when it meets Thursday. And it looks set to do nothing for longer than most investors anticipated.

Market players, especially on the other side of the Atlantic, seem increasingly puzzled by the ECB's reluctance to ease monetary policy in the face of an ever-stronger euro and with the credit crunch hitting Europe.

AP

But as ECB President Jean-Claude Trichet keeps repeating thatthe bank's only mission is fighting inflation. It does not care that in Spain and Ireland the housing market is in shambles and French and Italian exporters shout every time the euro sets another record high against the dollar.

And the latest inflation figures for the euro zone, a record 3.5 percent year-over-year, only diminish the prospect of a rate cut.

"Inflation is their primary focus, it's too early to signal a rate cut," Martin van Vliet, euro-zone economist at ING Bank, told CNBC.com. "They will keep rates at 4 percent for the coming two months … maybe in June they will signal they consider rate cuts in the second half of this year."

Cut Pushed to Fourth Quarter

Some economists think the ECB won't start easing until much later, as a slowdown in the real economy caused by the strong euro and the fallout of the financial markets turmoil is taking time to materialize.

"We think a rate cut will come in the fourth quarter," Stefan Schneider, chief international economist at Deutsche Bank, told CNCB.com. "The news flow on the inflation front is really going against the ECB."

Demand is still "surprisingly strong" in the euro zone, Schneider added.

Germany's closely-watched Ifo and ZEW sentiment indicators continued to show brimming confidence in March, while European Central Bank Governing Council member Axel Weber said no later than last Saturday that in Germany, first-quarter real gross domestic product growth has been "strong".

Another headache for the ECB arethe much-feared "second-round effects" -- actions from companies and governments on price rises, either by passing them on to consumers or yielding to trade union demands and increasing wages.

"The German public wage settlement certainly didn't help the ECB," Schneider said, referring to a 5.1 percent rise granted to German public sector workers, the biggest in 16 years.

Mission in Danger?

Trichet was quick to warn other governments against using the increase as a benchmark and central bank officials appealed to governments to help the ECB in its efforts to fight inflation.

Inflation expectations have risen, in tune with prices. A measure of inflation expectations comprised of the difference between French inflation-indexed bonds and similar maturity government bonds has "drifted higher in the recent weeks," van Vliet said.

"Almost half of the inflation comes from food and energy prices," he added. "But the problem is, if inflation remains way above the target, people start to embed this expectation and there are second-round effects."

Unlike the Federal Reserve, the ECB does not target growth, which probably makes its job a bit easier although it does not make it popular with politicians.

Gross domestic product growth is used only to gauge how inflation is likely to behave, and it's because of the signs of weakness already cropping up that monetary easing in the euro zone will be possible.

But if the slowdown in economic growth is too abrupt, because of the combined effects of a strong euro, a U.S. recession and tighter lending conditions, the ECB's obsession with inflation may come under scrutiny.

"If growth slows down more than we expect, it's a matter of time before the likes of (French President Nicolas) Sarkozy speak of a broader mandate for the ECB. But it's premature to speak about that yet," van Vliet said.

Contact Europe: Economy

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