Euro Zone Sentiment Falls, Jan. Inflation Confirmed

Euro zone economic sentiment fell more than expected in February to its lowest in over two years, highlighting risks to growth and boosting the chances of an ECB rate cut, despite a confirmed surge in January inflation.

Sentiment fell to 100.1 from January's 101.7, a monthly survey by the European Commission showed on Friday -- a much steeper dip than the decline to 101.2 expected by economists in a Reuters poll and the lowest reading since December 2005.

It was driven by declining optimism in the euro zone's services sector, which generates more than two thirds of the 15-member area's gross domestic product.

"(This) is worrying given the importance of the sector to the overall euro zone economy. This heightens concern about the strength of euro zone domestic demand going forward," said Howard Archer, chief European economist at Global Insight.

Industry and construction sentiment also deteriorated, while consumer optimism remained stable. Retail was the only sector to improve.

The European Commission last week cut its forecast for 2008 growth in the euro zone to 1.8 percent from 2.2 percent.

Economists expect the European Central Bank to follow suit when it presents its own growth forecasts on March 6.

Despite the deteriorating growth prospects the bank has signaled it is not ready to cut interest rates because of inflation which, Friday data confirmed, surged to a record 3.2 percent annually in January despite a 0.4 percent monthly fall.

That was in line with an earlier estimate by the European Union statistics office and market expectations. The ECB wants to keep annual inflation just below 2 percent but consumer prices took off in late 2007, boosted by food and energy.

Inflation to Rise Before it Falls

Economists said inflation could accelerate further to 3.3 percent in February before subsiding towards the ECB goal towards the year-end. Separate data from various euro zone countries on Friday seemed to confirm the pressure.

German February inflation defied expectations of an easing and remained at 2.8 percent. Price growth in Italy stayed at a record high of 3.1 percent and at 4.4 percent in Spain. Belgium reported inflation at 16-year highs on Thursday.

Eurostat will release its flash estimate of February inflation in the euro zone on Monday.

The ECB considers the inflation surge to be temporary, and is therefore keen to prevent expectations of fast price growth taking hold among consumers and businesses which could lead to an upward wage-price spiral.

The likelihood of upward pressure on wages is rising as unemployment in the euro zone remained at a record low of 7.1 percent in January, Eurostat data also showed on Friday.

Economists saw some inflation relief in a measure in the January data that excludes energy and food costs as well as alcohol and tobacco. That reading eased to 1.7 percent in annual terms from 1.9 percent in December.

"This trend should be confirmed in the coming months, as a significant slowdown in activity should help to moderate price pressures, which for the time being are still rather elevated," said Clemente de Lucia, economist at BNP Paribas.

The ECB also closely watches consumers' inflation expectations, which the Commission survey showed to be unchanged for a fourth straight month at 28 points, though above the long-term average of 23 points. Selling-price expectations among firms remained stable at 14 points.

The slowing growth, stable inflation expectations and an eventual slowdown in inflation should lead to ECB rate cuts, economists said.

"The greater risks to the economy now prevailing will ultimately prompt the bank to lower interest rates this year, provided of course that inflation falls substantially in the first half, as we expect it to do," said Christoph Weil, economist at Commerzbank.