Europe Economy

Is the Euro-Zone Tightening Cycle Over?

Last week in Budapest, the capital of one of the euro zone aspirant countries, European Central Bank President Jean-Claude Trichet left his options open for what will happen at the rate-setting meeting on Thursday.

The soft-spoken central banker, who loves predictability, was hoping for more clarity before taking a decision. But if anything, the past week and a half only added to the murkiness of an already foggy situation and the members of the ECB's governing council will have many topics on the agenda of the meeting, which just started.

"If you look at the fundamentals, there is still a case to be made to hike rates further, but there are so many uncertainties," Martin van Vliet, euro zone economist with ING Bank in Amsterdam, told "My guess is that they will first wait to see an easing in money market conditions."

Unlike the Federal Reserve, which has the twofold and sometimes conflicting mission of targeting both economic growth and inflation, the ECB's only mission is to "maintain price stability in the euro area."

While this should, in theory, mean the ECB has an easier ride than the Fed in deciding monetary policy, the recent developments show that this is not the case. Fed Chairman Ben Bernanke and President George Bush both echoed the message that the government is ready to help the economy if needed, but will not bail out speculators.

But the ECB President has not enjoyed the backing of politicians, facing pressure from various EU officials to halt rate hikes.

The recent market developments have given more ammunition tothose like French President Nicholas Sarkozy, who have long argued that the ECB's rate is too high and hurts the euro zone's exports.

Will the ECB Keep Interest Rates on Hold?

Vanished Predictability

The markets and the politicians now expect the ECB to refrain from hiking its key interest rate, because of the recent financial turbulences.

This is expected despite the fact that since he took office in November 2003, Trichet has developed a coded language by which he warns markets to expect a rate rise at the next meeting, to enforce predictability.

Judging by his statement mentioning "strong vigilance" on August 2, a 0.25% rate hike to 4.25% was onthe cards for Thursday's meeting. But the subsequent remark in Budapest last week that the ECB was not "pre-committed" threw those expectations out the window.

Also, before the meeting started, the ECB added 42.24 billion euros ($57.4 billion) to money markets to ease tensions on the euro interbank lending market. This increased speculation that the central bank may take a step similar to that of the Fed's last month and lower the 5% marginal lending facility at which it lends to commercial banks.

"It will take a little bit of time to see if these (subprime) events are going to trickle down to the real economy and until of course that is clear it would be a little bit too soon to continue with the interest rate hikes," Thanos Papasavvas, head of currency management at Investec Asset Management, told "Squawk Box Europe."

The fundamentals still point to a rate rise, despite a temporary fall in economic growth in the second quarter. Euro zone growth more than halved to 0.3% in the April to June period, in line with market expectations, mainly caused by a drop in investment and government spending.

But household spending, which in the first quarter was flat, jumped by 0.5%, suggesting consumption was expanding, which could put pressure on prices.

Unemployment was also steady at an all-time low of 6.9% in July, which should help household spending risein the coming months.

And inflation, although tame for the moment at 1.8% in August and in line with the ECB's "below, but close to 2%" target, shows clear signs of resurfacing. A monthly European Commission survey showed inflation expectations for 12 months increased in August for the first time in nine months.

"The primary responsibility of the central banks is to fight inflation … (the ECB) are going to hike interest rates as soon as they can," Allen Valentiner, director of research for fixed income at Johannes Fuhr Germany, told "Squawk Box Europe" ahead of the decision Thursday.

Tight Money Markets

Against this positive macroeconomic background, money market conditions have tightened over the past few weeks as banks' willingness to lend to each other diminished. Interbank rates such as the three-month EURIBOR have risen to record highs.

"Given the tensions in the money market … that already represents a tightening for the moment," van Vliet said.

In a sign that this is not just a euro zone problem, sterling three-month money market rates have also risen to the highest level in the past eight and a half years, prompting most analysts to predict that the Bank of England will keep its benchmark interest rate on hold at 5.75% on Thursday.

Trichet's hopes for a clearer outlook from the latest data look dashed. Unless, of course, the head of the ECB knows something we don't know -- a phrase increasingly popular among market players.

The main question -- to what extent the U.S. subprime crisis and the subsequent risks from the sliced, diced and repackaged debt have affected European banks and the economy -- has so far remained unanswered.

Shares in two of Europe's biggest banks, U.K's Barclays and Germany's Deutsche Bank, surged after their CEOs said their exposure to the crisis was limited. Even in the absence of a breakdown of the figures, investors were reassured by the fact that officials finally said something about it.

Nevertheless, news of more subprime problems trickles in daily and some analysts call the subprime crisis just the tip of the iceberg.

Trichet usually likes to stress that monetary policy should be forward-looking. In other words, it should assess the risks to come, not just the current ones.

But in the present situation, his only option may be just to wait for the fog to clear.