---- by STEVE WHITEHOUSE ----
PARIS (AFX) - The European Central Bank will leave interest rates unchanged at today's governing council meeting, but further cuts in rates are expected in the third quarter, economists said.
The ECB surprised markets by cutting leading interest rates at its last council meeting on May 10 after many council members had insisted in the run-up to the meeting that they were concerned about inflationary pressures.
ECB president Wim Duisenberg said the decision was the result of "somewhat lower inflationary pressure over the medium term" and this means that the way is open for further monetary easing in the months ahead, economists said.
It is too early to cut interest rates again this week, but another easing move is likely in the third quarter, or possibly even in June, they said.
In a poll of 27 economists last week by AFX News and Agence France-Presse, all said they expect the minimum bid rate on the ECB's main refinancing operations to be left unchanged at 4.50 pct at today's meeting.
The majority of those polled -- 17 of the 27 -- forecast that the next easing move will come in the third quarter. Five predicted that rates will be cut in June, while three said the ECB will ease in either June or July. One forecast a fourth quarter easing move and one said he expects no move over the next 12 months.
Economists therefore appear to be paying little heed to Bundesbank president Ernst Welteke's remark that the May 10 cut was "not an appetizer".
"Now that the ECB has decided to become more reactive, it has to continue in the same direction," said Marc Touati of Natexis Banques Populaires, who was alone in forecasting a cut at the May 10 meeting. "The fact that the ECB considers inflation risks to have evaporated will mean that rate cut expectations will take shape again as (weak) economic indicators are released," said Emmanuel Ferry of Exane. "We are reckoning on a more decisive cut of 50 basis points on June 7, in view of the negative news flow ahead, not only in Germany but also in Italy and, to a lesser extent, in France," he said.
The timing of the next rate cut may be partly affected by inflation figures, although the fact that euro zone inflation was well above the ECB's 2.0 pct price stability ceiling did not deter the central bank from easing rates at its last meeting.
At that time inflation stood at 2.6 pct, but April figures released last week showed it accelerating to 2.9 pct, and economists said it is likely to rise again in May.
Inflation is likely to ease again with the June data released in July and this could give the ECB justification for a further rate cut, economists said.
"The ECB is doubtless waiting to have a more favourable inflation figure before cutting rates again," said Frederic Pretet of Credit Agricole Indosuez, who expects an easing move in late July or early August.
However, the May 10 cut has shown that the ECB is paying only limited attention to current headline inflation figures. Duisenberg insisted that the ECB is focussing on risks to price stability in the medium-term future, which he defined as 18-24 months ahead.
ECB vice-president Christian Noyer said markets had been mistaken in assuming that the central bank was targeting short-term inflation, whereas it is actually targeting inflation in the medium term.
And medium-term inflation expectations are more benign than the current headline rate, economists noted.
"Given that Euroland industry price prospects in the European Commission survey are presently at their lowest level since December 1999, the ECB should ease monetary policy again," said Touati. The ECB also regards M3 money supply growth as very important to future inflation risks, and it pinned the May 10 rate cut largely on new information on distortions in the M3 data.
Duisenberg said the distortions, relating to the inclusion of non-resident holdings of marketable paper in the M3 data, meant that the risk to price stability from monetary growth had been overstated in the past.
And once the distortions are removed, M3 growth is now thought to be undershooting, rather than overshooting, the ECB's 4.5 pct reference value, economists said.
Duisenberg said M3 growth would have averaged 4.3 pct in the first quarter, rather than the published figure of 4.8 pct, if non-resident holdings of units and shares in money market funds had not been included.
And in its May monthly bulletin last week, the ECB said a second distortion that it is studying could be of similar magnitude to the first, which would mean that M3 growth is running at around 3.8 pct after adjusting for both distortions.
Such a rate of M3 growth could well be used to justify another rate cut, economists said.
Signs of weaker economic growth could also be used as an argument for additional monetary easing, they said.
Although the ECB is mandated to put price stability before considerations of economic growth, Duisenberg cited downward revisions in euro zone growth forecasts as the second reason for the May 10 rate cut, so the ECB clearly has one eye on European growth, they said. "Given the apparent shift in the focus of the ECB towards short-term risks to growth, it is not unlikely that there will be more rate cuts. This is especially the case as euro area indicators should continue to be weak over the summer," said Michael Schubert of Commerzbank.
"Further economic slowdown and a slowing in the headline inflation rate will become apparent by end of June. It will take until then too for the dust to have settled from last week's surprising decision. By the beginning of the third quarter, the ECB could therefore cut rates again," said Julian von Landesberger of HypoVereinsbank.
Economists said they will certainly be paying more attention to economic data than to remarks from ECB officials, having been wrongfooted by their comments in the run-up to the May 10 meeting. Comments and speeches are now regarded as having limited value in forecasting future interest rate decisions, despite Duisenberg's previous commitment to prepare markets for rate moves where possible. The ECB's credibility has been seriously damaged by the contradiction between words and actions, economists said.
"In spite of Mr Duisenberg's justifications, the May 10 rate cut was another blow to the credibility of the ECB. After convincing the markets of the need to maintain a tough stance against inflationary risks, the U-turn of the monetary authorities increased confusion," said Rodolfo Dozio of Comit.
The ECB has a chance to regain some credibility by easing monetary policy further, however, Touati said.
"In this way it can climb a few rungs on the credibility ladder...whereas on the other hand the Fed risks going down a few rungs as a result of a policy which is a bit too brutal. This could finally bring about a lasting improvement in the fortunes of the euro," he said.