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How Long Can the ECB Stand Pat?

The European Central Bank will most likely do on Thursday what it has done every month since the credit crunch started last August: keep rates steady and talk tough on inflation.

But the bank risks blunting its verbal monetary-policy tool if it keeps repeating the same message.And ECB President, Jean-Claude Trichet could be in for some tough questions at the press conference in Athens after the decision.

European Central Bank President Jean-Claude Trichet
AP
European Central Bank President Jean-Claude Trichet

"One question may be, 'if you're so worried about inflation, why aren't you hiking?'", Stuart Bennet, senior European economist at Calyon told CNBC.com. "In essence they are conceding they take on board the currency and the growth outlook."

Two weeks ago, remarks from some hawkish members of the ECB governing council raised the possibility that a rate rise was in the cards, despite increasing signs of weakness in the euro zone. The bank's only mission is to fight inflation.

Austrian member Klaus Liebscher said in mid-April that he did not see any room for rate cuts but could not rule out a rate rise in the final months of the year.

Well-known German hawk Axel Weber said he was worried the inflation rate would remain high because of wage and fiscal policy.

"Should indications of this increase, we must react with interest rate policy," Weber added.

And even France's Christian Noyer said last month the ECB's problem was to ensure that inflation goes back below 2 percent next year and that it will do whatever is needed, even move interest rates, to achieve that goal.

No Cuts Yet

Despite these intentions, though, the ECB will stand pat, stuck between high inflation and slowing growth, analysts said.

"I think Trichet will point out that the interest-rate level is appropriate," Veronika Lammer, euro-zone economist, Erste Bank Vienna, told CNBC.com. "I don't think that they will open a window in the direction of interest-rates cuts."

Not yet, anyway. But with signs of weakness across the board, most analysts predict that rates will be below 4 percent by the end of the year. The big question is when will the ECB start to change its rhetoric from hawkish to dovish?

"For the time being they sort of painted themselves in a corner. The economy is much weaker than they're making out," Bennet said.

At a glance, the most recent figures paint a rosy picture. On Tuesday, the euro zone April services PMI was revised up to 52.0 from the provisional estimate of 51.8, compared with the March reading of 51.6.

But a breakdown of the figures shows that there was only one prominent winner in the euro zone. German services PMI jumped to 54.9 from 51.8, and the April figure was revised up from a provisional 54.6.

But the French April services PMI was revised down to 52.8 from a provisional 54.0, falling sharply from the March figure of 57.3 and reaching its lowest level since August 2003.

The Italian and Spanish indexes rose but remained below the 50 mark between expansion and contraction. Italy's services PMI rose to 49.8 in April from 48.8 in March, while the Spanish reading increased to 42.5 from 40.9.

German Bias?

This latest data may fuel the long-running debate on whether the ECB's policy is in fact set for Germany, brushing aside the needs of the other 14 economies in the euro zone.

"What the sentiment surveys show is that without Germany, Europe is really in trouble," Bennet said. "I'm sure that must come up in discussions, even if Trichet doesn't highlight it in the conference."

However, the Ifo German business climate index dropped to 102.4 in April from 104.8 in March, showing that even the euro zone's hero was not immune to the world economic woes.

Meanwhile, Spanish industrial output fell and unemployment rose, as the main driver of economic growth, the construction sector, undergoes a correction, data showed on Tuesday.

Along with Spain, Italy too underperformed in the manufacturing sector in May, in a sign that the strong euro was finally biting into growth.

But the times of the rising single European currency are gone, analysts said, as its strength against the U.S. dollar and other currencies has in fact provided tight monetary conditions.

On Thursday morning, the euro fell to a two-month low against the dollar, with a sharp drop in euro zone retail sales reigniting worries about the region's economic outlook.

"We don't think the euro will get above $1.60 and we think it will be weaker. It is just too high," Lammer said.

The euro will trade around $1.48 towards the end of this year, and around $1.30 at the end of next year, she predicted.

Contact Europe: Economy

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